Measuring the Moat (Updated Version)

Credit Suisse’s Global Financial Strategies team has published an updated version of the report, “Measuring the Moat.” It includes new charts and examples and reflects the latest academic research.

Measuring the Moat: Assessing the Magnitude and Sustainability of Value Creation 

• Sustainable value creation is of prime interest to investors who seek to anticipate expectations revisions.
• This report develops a systematic framework to determine the size of a company’s moat.
• We cover industry analysis, firm-specific analysis, and firm interaction.

See here for a collection of links to other Mauboussin papers.

Measuring the Moat: Value Creation Checklist

“The most important thing to me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.” ―Warren Buffett

Measuring the Moat: Assessing the Magnitude and Sustainability of Value Creation

Below is an excerpt of “a complete checklist of questions to guide the strategic analysis” published in the paper Measuring the Moat: Assessing the Magnitude and Sustainability of Value Creation, written by Michael J. Mauboussin and Dan Callahan.

See here for full PDF.

Value Creation Checklist

• What stage of the competitive life cycle is the company in?
• Is the company currently earning a return above its cost of capital?
• Are returns on capital increasing, decreasing, or stable? Why?
• What is the trend in the company’s investment spending?

Lay of the Land

• What percentage of the industry does each player represent?
• What is each player’s level of profitability?
• What have the historical trends in market share been?
• How stable is the industry?
  • How stable is market share?
  • What do pricing trends look like?
• What class does the industry fall into—fragmented, emerging, mature, declining, international, network, or hypercompetitive?

The First Three of the Five Forces

• How much leverage do suppliers have?
• Can companies pass supplier increases to customers?
• Are there substitute products available?
• Are there switching costs?
• How much leverage do buyers have?
• How informed are the buyers?

Barriers to Entry

• What are the entry and exit rates like in the industry?
• What are the anticipated reactions of incumbents to new entrants?
• What is the reputation of incumbents?
• What is the level of asset specificity?
• What is the minimum efficient production scale?
• Is there excess capacity in the industry?
• Is there a way to differentiate the product?
• What is the anticipated payoff for a new entrant?
• Do incumbents have precommitment contracts?
• Do incumbents have licenses or patents?
• Are there learning curve benefits in the industry?

Rivalry

• Is there pricing coordination?
• What is the industry concentration?
• What is the size distribution of firms?
• How similar are the firms in incentives, corporate philosophy, and ownership structure?
• Is there demand variability?
• Are there high fixed costs?
• Is the industry growing?

Disruption and Disintegration

• Is the industry vulnerable to disruptive innovation?
• Do new innovations foster product improvements?
• Is the innovation progressing faster than the market’s needs?
  • Have established players passed the performance threshold?
  • Is the industry organized vertically, or has there been a shift to horizontal markets?

Firm Specific

• Does analysis of the value chain reveal what activities a company does differently than its its rivals?
• Does the firm have production advantages?
  • Is there instability in the business structure?
  • Is there complexity requiring know-how or coordination capabilities?
  • How quickly are the process costs changing?
• Does the firm have any patents, copyrights, trademarks, etc.?
• Are there economies of scale?
  • What does the firm’s distribution scale look like?
  • Are assets and revenue clustered geographically?
  • Are there purchasing advantages with size?
  • Are there economies of scope?
  • Are there diverse research profiles?
• Are there consumer advantages?
  • Is there habit or horizontal differentiation?
  • Do people prefer the product to competing products?
  • Are there lots of product attributes that customers weigh?
  • Can customers only assess the product through trial?
  • Is there customer lock-in? Are there high switching costs?
• Is the network radial or interactive?
• What is the source and longevity of added value?
• Are there external sources of added value (subsidies, tariffs, quotas, and competitive or environmental regulations)?

Firm Interaction—Competition and Coordination

• Does the industry include complementors?
• Is the value of the pie growing because of companies that are not competitors? Or, are new companies taking share from a pie with fixed value?

Brands

• Do customers want to “hire” the brand for the job to be done?
• Does the brand increase willingness to pay?
• Do customers have an emotional connection to the brand?
• Do customers trust the product because of the name?
• Does the brand imply social status?
• Can you reduce supplier operating cost with your name?

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.

Measuring the Moat

Building a framework for measuring the moat

It is of utmost importance for an investor to know the concept of competitive advantages, what Warren Buffett refers to as a moat.  Another dimension that also is imporotant is the sustainability of any competitive advantages identified.

A great way to improve knowledge in this area is to read the report Measuring the Moat – Assessing the Magnitude and Sustainability of Value Creation written by Michael J. Mauboussin and Dan Callahan, both currently at Credit Suisse.

A few glimpses of the content of the report is found on the front page:

• Sustainable value creation is of prime interest to investors who seek to anticipate expectations revisions.
• This report develops a systematic framework to determine the size of a company’s moat.
• We cover industry analysis, firm-specific analysis, and firm interaction.

Executive Summary

The first part of the report is a summary of the topics discussed in it. This section is included below.

• Sustainable value creation has two dimensions—how much economic profit a company earns and how long it can earn excess returns. Both dimensions are of prime interest to investors and corporate executives. 
• Sustainable value creation as the result solely of managerial skill is rare. Competitive forces drive returns toward the cost of capital. Investors should be careful about how much they pay for future value creation. 
• Warren Buffett consistently emphasizes that he wants to buy businesses with prospects for sustainable value creation. He suggests that buying a business is like buying a castle surrounded by a moat and that he wants the moat to be deep and wide to fend off all competition. Economic moats are almost never stable. Because of competition, they are getting a little bit wider or narrower every day. This report develops a systematic framework to determine the size of a company’s moat. 
• Companies and investors use competitive strategy analysis for two very different purposes. Companies try to generate returns above the cost of capital, while investors try to anticipate revisions in expectations for financial performance. If a company’s share price already captures its prospects for sustainable value creation, investors should expect to earn a risk-adjusted market return. 
• Industry effects are the most important in the sustainability of high performance and a close second in the emergence of high performance. However, industry effects are much smaller than firm-specific factors for low performers. For companies that are below average, strategies and resources explain 90 percent or more of their returns. 
• The industry is the correct place to start an analysis of sustainable value creation. We recommend getting a lay of the land, which includes a grasp of the participants and how they interact, an analysis of profit pools, and an assessment of industry stability. We follow this with an analysis of the five forces and a discussion of the disruptive innovation framework. 
• A clear understanding of how a company creates shareholder value is core to understanding sustainable value creation. We define three broad sources of added value: production advantages, consumer advantages, and external advantages. 
• How firms interact plays an important role in shaping sustainable value creation. We consider interaction through game theory as well as co-evolution. 
• Brands do not confer competitive advantage in and of themselves. Customers hire them to do a specific job. Brands that do those jobs reliably and cost effectively thrive. Brands only add value if they increase customer willingness to pay or if they reduce the cost to provide the good or service. 
• We provide a complete checklist of questions to guide the strategic analysis in Appendix A.