Hallmarks of superb businesses
Differentiators other than price
In the last little while I have written several posts delving into Warren Buffett’s moats. They have looked at the economic forces that shape moats, ways to measure sustainable shareholder value creation using ROIC and problems with ROIC as a metric.
Today’s post continues with the moat theme but looks at the question of whether some sources of moats are better than others. We will look at some research that shows moats based on product differentiation business strategies tend to produce greater long term shareholder value than strategies based on cost leadership.
Five sources of economic moats
It is conventionally accepted today that there are five sources of moats. They are: 1) network effect; 2) intangible assets; 3) cost advantage; 4) switching costs; and, 5) efficient scale.
For readers not familiar with economic moats let me use Morningstar’s description to set the scene:
What Morningstar is looking for in its assessment of moats was contained in a Morningstar report written by Matthew Coffina, CFA, and published on Yahoo Finance January 30, 2014.
“A company with a very profitable business is like a castle that is constantly under attack by competitors. Without a strong defense, competitors will soon imitate the company’s products, charge lower prices, steal market share, and erode profit margins to the point where the business is merely average, at best.
Economic moats—a term Morningstar borrowed from Warren Buffett—are what keep competitors at bay. An economic moat is a sustainable competitive advantage that allows a company to earn excess returns on capital for a long period of time. Morningstar analysts assign every company in our coverage universe an economic moat rating: either wide, narrow, or none.
The most important quantitative evidence of an economic moat is a high return on invested capital, or ROIC. Investors—both shareholders and creditors—require a certain level of return in exchange for providing a company the funds it needs to run its business. This is called the weighted average cost of capital, or WACC. A company generates excess returns if its ROIC consistently exceeds its WACC.
“Morningstar has identified five potential sources of an economic moat, which are described below. Every company with an economic moat rating of wide or narrow exhibits at least one of these sources of advantage, and in some cases more than one.
Network Effect. The network effect occurs when the value of a company’s service increases for both new and existing users as more people use the service. For example, millions of buyers and sellers on eBay (EBAY) give the company an advantage over other online marketplaces. The more sellers there are on eBay, the more likely buyers are to find what they’re looking for at a decent price. The more buyers there are, the easier it is to sell things.
Intangible Assets. Patents, brands, regulatory licenses, and other intangible assets can prevent competitors from duplicating a company’s products, or allow the company to charge a significant price premium. For example, patents protect the excess returns of pharmaceutical manufacturers such as Novartis (NVS). When patents expire, generic competition can quickly push the prices of drugs down 80% or more.
Cost Advantage. Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or they can charge market-level prices while earning relatively high margins. For example, Express Scripts (ESRX) controls such a large percentage of U.S. pharmaceutical spending that it can negotiate favorable terms with suppliers like drug manufacturers and retail pharmacies.
Switching Costs. When it would be too expensive or troublesome to stop using a company’s products, the company often has pricing power. Architects, engineers, and designers spend entire careers mastering Autodesk’s (ADSK) software packages, creating very high switching costs.
Efficient Scale. When a niche market is effectively served by one or a small handful of companies, efficient scale may be present. For example, midstream energy companies such as Enterprise Products Partners (EPD) enjoy a natural geographic monopoly. It would be too expensive to build a second set of pipes to serve the same routes; if a competitor tried this, it would cause returns for all participants to fall well below the cost of capital.” (Emphasis Added)
Different ways to skin the cat
Let’s assume you are looking to invest some hard-earned money. You are looking at two company candidates. They both have wide moats. They are both reckoned to enjoy a high and sustainable spread between ROIC and WACC. How do you choose?
One way is to take a look at each company’s business strategy. Let’s say company ‘A’ has a structural cost advantage that just can’t be matched by its competitors. The company is successful because of cost leadership. One of the noteworthy features of company ‘A’, that will go hand in hand with its cost leadership, is that it will exhibit high invested capital turnover which is good.
Now let’s look at company ‘B’. Its basic strategy is not cost leadership but to differentiate its products or services from its competitors.
Company ‘A’ and company ‘B’ represent two different business strategies.
Michael J. Mauboussin and Dan Callahan, in a report dated October 15, 2024 titled Measuring the Moat Assessing the Magnitude and Sustainability of Value Creation. , refer to research done by Raynor and Ahmed in which they looked into the business strategies of companies that really were exceptional performers.
In the research, it was a given that all companies had great stats when it came to wide moats and high and sustainable ROIC to WACC spreads. What they were looking for was the secret sauce that drove some companies to the most outstanding sustained value creation.
Mauboussin and Callahan tell us: “The researchers “asked whether those companies [most outstanding sustained value creation] had any common behaviors. They did not see similarity in actions but they did observe that the companies consistently reasoned in the same way. That thought process was a strategy of differentiation. Raynor and Ahmed suggest that successful companies operate with two rules: better before cheaper, which means competing on differentiators other than price; and revenues before cost, which means prioritizing growing sales revenue over reducing costs.” (Emphasis added)
NOPAT margins
The differentiator between the two types of companies was NOPAT margins. So, while both types of companies enjoyed high and sustainable spreads between ROIC and WACC, companies with high NOPAT margins were found to follow a differentiation strategy and drove more outstanding sustained value creation. NOPAT is net operating profits after taxes. If you start with EBIT, earnings before interest and taxes and add back interest costs, you get NOPAT. It is after tax but not after interest costs.
NOPAT margins are a kind of profit margin.
This is illustrated in the following chart. The bottom right of the exhibit, companies with high NOPAT margins and low invested capital turnover, is where companies reside when they succeed with a differentiation strategy. The top left, companies with low NOPAT margins and high invested capital turnover, features companies with a cost leadership strategy.
Mauboussin and Callahan sum it up this way: “The insight is companies that enjoy attractive ROICs via a differentiation strategy tend to have high NOPAT margins and satisfactory invested capital turnover. Companies that are successful because of cost leadership generally have satisfactory NOPAT margins and high invested capital turnover.”
“…companies can achieve the same level of ROIC (high and sustainable spread between ROIC and WACC) using vastly different approaches: Cost Leadership (high invested capital turnover) and Differentiation (NOPAT Margin (Percent)
While both strategies can lead to value creation, some research suggests that differentiation is more commonly associated with outstanding long-term results.” (Emphasis added)
Simply put, as investors, to take advantage of this benefit we would want to favour high profit margin businesses over cost leadership businesses.
The use of NOPAT is said to allow comparison between companies with differing debt structures. I don’t like this. Since I am not so much comparing companies but assessing them as individual business, I prefer to simply look at a company’s operating margins or net margins.
Pricing power
In an interview with the Financial Crisis Inquiry Commission in 2010 Warren Buffett said:
“The single-most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business. I’ve been in both, and I know the difference.”
NOPAT margins and pricing power
If a company has a wide moat and enjoys high operating margins, you are on firm ground to conclude the company has pricing power. This will be our company ‘B’.
Remember, our company ‘A’ has a structural cost advantage that just can’t be matched by its competitors. The company is successful because of cost leadership. One of the noteworthy features of company ‘A’, that will go hand in hand with its cost leadership, is that it will exhibit high invested capital turnover. But it’s cost advantage does not give it pricing power.
Fisher and Buffett
Philip Fisher, who had a great influence on Warren Buffett, placed a great deal of emphasis on profit margins. Fisher believed that “from the standpoint of safety of investment all the emphasis is on profit margin on sales.” (Fisher, Common Stocks and Uncommon Profits 1958,1996) p199.
High profit margins are a reflection of a business’ inherent characteristics that make possible an above-average profitability for as long as can be foreseen into the future. In words that Warren Buffett would warmly approve, Fisher writes: “Some companies are in the seemingly fortunate position that they can maintain profit margins simply by raising prices.”
Buffett believed that the ability to regularly raise prices is one of the defining characteristics of a moatworthy business.
Summing up
We have learned from Mauboussin and Callahan that a company enjoying a wide moat by virtue of Cost Leadership (reflected in high invested capital turnover) may not create the best long term shareholder value. These businesses reflect a cost advantage moat. Companies enjoying a wide moat through a business strategy of competing on differentiators other than price (NOPAT Margin (Percent) will tend to create the best long term shareholder value. These businesses may enjoy moats based on networks, intangibles or switching costs or some combination of moats. Sustained high profit margins may very well be a reflection of pricing power.
Note that a company may enjoy a wide moat but not appear to have strong metrics like ROIC/WACC spreads (eg Amazon) or may have strong metrics over an extended time but not have a wide moat (e.g. many oligopolies). Moats are assessed based on a combination of quantitative analysis and qualitative analysis.
Conclusion
Nothing in investing is certain. We have to go with getting the probabilities on our side. Chances are that if you can invest in companies with wide moats and pricing power, the value of your investments will march upwards over the years, although perhaps not steadily.
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