”The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”
”ESCAPING COMPETITION will give you a monopoly, but even a monopoly is only a great business if it can endure in the future.”
—Peter Thiel, Zero to One
Are you buying an asset or a franchise?
Let’s start with some thinking about investing, what you buy, and why you buy it.
In the end, for any single investment you’ll make, it’s all about the risk and inflation adjusted after tax return on invested capital net of any expenses. When you invest you are giving up money that could have been used to buy goods or services today, with the aim of (hopefully) receiving more in the (unknown) future.
One critical questions to consider and answer for each business you invest in is: “Are you buying an asset or a franchise?”
In his 1991 letter to shareholders Warren Buffett provided a definition of a franchise:
An economic franchise arises from a product or service that: (1) is needed or desired; (2) is thought by its customers to have no close substitute and; (3) is not subject to price regulation. The existence of all three conditions will be demonstrated by a company's ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital. Moreover, franchises can tolerate mis-management. Inept managers may diminish a franchise's profitability, but they cannot inflict mortal damage.
In contrast, "a business" earns exceptional profits only if it is the low-cost operator or if supply of its product or service is tight. Tightness in supply usually does not last long. With superior management, a company may maintain its status as a low-cost operator for a much longer time, but even then unceasingly faces the possibility of competitive attack. And a business, unlike a franchise, can be killed by poor management.
(Source: Warren Buffett, Shareholder Letter, 1991)
What Buffett calls “a business,” is what I earlier named an “asset.” In theory, what Buffett calls “a business” is a business that does not have a sustainable competitive advantage, i.e., no moat, and thus is not able to earn any economic profits, i.e., a return on invested capital (ROIC) above its cost of capital (COC). The invested capital (assets) in a business like this does not generate any excess value since ROIC equals COC, and the business is only worth the value of its assets.
In contrast, a franchise is a business that earns a ROIC above its COC, and in a situation like this the earning power of the business will result in a intrinsic value exceeding the value of the assets. For this to be sustainable, and for you to go on and base your valuation from the future earning power of the business, there must be some characteristics of the business that makes it possible to defend these excess profits from any competitors that will try to take these profits away. A wide moat (sustainable competitive advantage) will make sure this does not happen—then the next question to consider is the durability of the moat, i.e., how long the business will be able to defend its excess profits. If there is no moat, incumbents have no advantage over entrants and all excess profits will be competed away—maybe not in the short term, but it will happen over the long haul.
A stock selection framework when trying to answer this question—see image below—was originally published in The Manual of Ideas: The Proven Framework for Finding the Best Value Investment, written by John Mihaljevic.
Depending on your answer to the question (asset or franchise), there are two different ways when approaching your analysis: (1) asset value analysis or (2) earning power analysis. When looking at a franchise, that is, a business enjoying a sustainable competitive advantage (or a moat with lots of piranhas in it) the analysis will focus on the earning power of the business.
In the beginning of the book Mihaljevic describes the stock selection framework as follows.
Figure 1.2o outlines an approach that may be able to handle, at least in principle, the vast array of equity investment opportunities available in the public markets. Although the following framework may not be practicable for most small investors, it does illustrate how we may think about security selection if we adopt the mindset of chief capital allocator.
The stock selection framework begins by asking whether the net assets are available for purchase for less than replacement cost. If this is not the case, we exclude the company from consideration because it might be cheaper to re-create the equity in the private market. If the equity is available for less than replacement cost, then we consider whether it is so cheap that liquidation would yield an incremental return. If this is the case, we may consider liquidating the equity. In the vast majority of cases, an equity will trade far above liquidation value, in which case we turn our attention to earning power.
Once we focus on the earning power of a going concern, the key consideration becomes whether the business will throw off sufficient income to allow us to earn a satisfactory return on investment. Many related considerations enter the picture here, including the relationship between net income and free cash fl ow, the ability of the business to reinvest capital at attractive rates of return, and the nature of management ’s capital allocation policies.
From Zero to One, or Asset to Franchise
Zero to One, written by Peter Thiel, is a book about ”how to build companies that create new things.” The book is based on a course that Thiel held about startups at Stanford in 2012, and ”the primary goal in teaching the class was to help [his] students see beyond the tracks laid down by academic specialties to the broader future that is theirs to create.”
As always, there is no one formula to find. Instead, there are principles.
”The paradox of teaching entrepreneurship is that such a formula necessarily cannot exist; because every innovation is new and unique, no authority can prescribe in concrete terms how to be innovative. Indeed, the single most powerful pattern I have noticed is that successful people find value in unexpected places, and they do this by thinking about business from first principles instead of formulas.”
Zero to One is about a few things to consider in building a business from the start. Although the book focuses on venture capital and startups, it’s worth reading for everyone interested in business analysis and investing. Why? It discusses the difference between a great business, a business with a sustainable competitive advantage (or “monopoly”), and and businesses that doesn’t enjoy any competitive advantage at all and is bound for a hard struggle for any profits available in a highly competitive market (in theory, the cost of capital since economic profits are competed away).
The value of a business today comes from the cash inflows and outflows that can be expected to occur during the remaining life of the asset discounted at an appropriate interest rate. So, when thinking about the value of any business, future cash flows is highly critical, and at the same time highly uncertain.
One section in the book is called Monopoly Characteristics and devoted to a discussion of what characteristics (i.e., competitive advantages) to look for in a business. Thiel starts by asking a central question:
”What does a company with large cash flows far into the future look like? Every monopoly is unique, but they usually share some combination of the following characteristics: proprietary technology, network effects, economies of scale, and branding.”
Further Thiel notes that:
”This isn’t a list of boxes to check as you build your business—there’s no shortcut to monopoly. However, analyzing your business according to these characteristics can help you think about how to make it durable.”
Characteristics of Monopoly to Look For
Thiel asks and discusses a critical question when it comes to businesses and investing: “What does a company with large cash flows far into the future look like?” This is pretty close to the one-million dollar question. But Thiel also provides a discussion of the different characteristics to look for in our analysis of different businesses. According to Thiel “[e]very monopoly is unique, but they usually share some combination of the following characteristics: proprietary technology, network effects, economies of scale, and branding.”
Below each one of the different characteristics is summarized with all of the quotes below taken from the book.
Monopoly Characteristic Nr. 1: Proprietary Technology
Definition: “Proprietary technology is the most substantive advantage a company can have because it makes your product difficult or impossible to replicate.”
Two different ways: (1) invent something completely new, or (2) radically improve an existing solution.
- Invent something completely new: “Google’s search algorithms, for example, return results better than anyone else’s. Proprietary technologies for extremely short page load times and highly accurate query autocompletion add to the core search product’s robustness and defensibility. It would be very hard for anyone to do to Google what Google did to all the other search engine companies in the early 2000s.”
- Radically improve on an existing solution: “Or you can radically improve an existing solution: once you’re 10x better, you escape competition. PayPal, for instance, made buying and selling on eBay at least 10 times better. Instead of mailing a check that would take 7 to 10 days to arrive, PayPal let buyers pay as soon as an auction ended. Sellers received their proceeds right away, and unlike with a check, they knew the funds were good. Amazon made its first 10x improvement in a particularly visible way: they offered at least 10 times as many books as any other bookstore. When it launched in 1995, Amazon could claim to be “Earth’s largest bookstore” because, unlike a retail bookstore that might stock 100,000 books, Amazon didn’t need to physically store any inventory—it simply requested the title from its supplier whenever a customer made an order. This quantum improvement was so effective that a very unhappy Barnes & Noble filed a lawsuit three days before Amazon’s IPO, claiming that Amazon was unfairly calling itself a “bookstore” when really it was a “book broker.”You can also make a 10x improvement through superior integrated design. Before 2010, tablet computing was so poor that for all practical purposes the market didn’t even exist. “Microsoft Windows XP Tablet PC Edition” products first shipped in 2002, and Nokia released its own “Internet Tablet” in 2005, but they were a pain to use. Then Apple released the iPad. Design improvements are hard to measure, but it seems clear that Apple improved on anything that had come before by at least an order of magnitude: tablets went from unusable to useful.”
Examples: Google, PayPal, and Amazon.
Rule of thumb: Must be “at least 10 times better than its closest substitute in some important dimension to lead to a real monopolistic advantage.”
Monopoly Characteristic Nr. 2: Network Effects
Definition: ”Network effects make a product more useful as more people use it.”
Examples: “For example, if all your friends are on Facebook, it makes sense for you to join Facebook, too. Unilaterally choosing a different social network would only make you an eccentric.”
Rule of thumb: “Network effects can be powerful, but you’ll never reap them unless your product is valuable to its very first users when the network is necessarily small. … Paradoxically, then, network effects businesses must start with especially small markets. Facebook started with just Harvard students—Mark Zuckerberg’s first product was designed to get all his classmates signed up, not to attract all people of Earth. This is why successful network businesses rarely get started by MBA types: the initial markets are so small that they often don’t even appear to be business opportunities at all.”
Monopoly Characteristic Nr. 3: Economies of Scale
Definition: ”A monopoly business gets stronger as it gets bigger: the fixed costs of creating a product (engineering, management, office space) can be spread out over ever greater quantities of sales. Software startups can enjoy especially dramatic economies of scale because the marginal cost of producing another copy of the product is close to zero.”
Rule of thumb: ”Many businesses gain only limited advantages as they grow to large scale. Service businesses especially are difficult to make monopolies. If you own a yoga studio, for example, you’ll only be able to serve a certain number of customers. You can hire more instructors and expand to more locations, but your margins will remain fairly low and you’ll never reach a point where a core group of talented people can provide something of value to millions of separate clients, as software engineers are able to do.”
Examples: ”A good startup should have the potential for great scale built into its first design. Twitter already has more than 250 million users today. It doesn’t need to add too many customized features in order to acquire more, and there’s no inherent reason why it should ever stop growing.”
Monopoly Characteristic Nr. 4: Branding
Definition: ”A company has a monopoly on its own brand by definition, so creating a strong brand is a powerful way to claim a monopoly.”
Rule of thumb: ”Beginning with brand rather than substance is dangerous.”
Examples: ”Today’s strongest tech brand is Apple: the attractive looks and carefully chosen materials of products like the iPhone and MacBook, the Apple Stores’ sleek minimalist design and close control over the consumer experience, the omnipresent advertising campaigns, the price positioning as a maker of premium goods, and the lingering nimbus of Steve Jobs’s personal charisma all contribute to a perception that Apple offers products so good as to constitute a category of their own.”
Competitive Advantages Framework
I have written about the subject of competitive advantages earlier, and put together the “Competitive Advantages Framework” as a way to keep the most important parts in one and the same place. As we noted earlier, there is no single formula, instead there are principles to guide us in our analysis and understanding.
Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.