Companies may have their surprises, but they are much easier to predict than markets. There are signs when a company enjoys a structural competitive advantage – a ‘moat’ as Warren Buffett dubbed it – enabling persistent profitability. These businesses are hard to find but over the long term their shares can strongly outperform.
How to identify these companies? A first step is to calculate their return on invested capital (ROIC) and weighted average cost of capital (WACC) (see above). Note if the company’s ROIC enjoys a healthy spread over its WACC; then ask if that spread is expanding or contracting. Now find out why: a ROIC-WACC spread expanding ephemerally is of scant use, but a persistent economic profit (see above) is a sign of structural advantage. Economic profits attract competitors like bees to honey, so think hard about whether the company is well-positioned to withstand the attack. Does it have a moat around
it, or will its economic profits be eroded with time? Four examples of structural advantages that protect a company’s economic profits, and which can lead to long-term share price outperformance, are: network effect, cost advantage, switching costs, and intangible assets.
After identifying these quality businesses, a good investment also requires that we buy their shares at a reasonable price, with as much margin of safety as possible. We use a discounted cashflow model to help us decide if shares are trading below their intrinsic value. In 2018 there have been opportunities to buy good companies in emerging markets cheaply, and this gives us confidence for the future.
Network effect is where the value of a service increases the more that people use it (think: social media). Companies lifted by the network effect are in a happy place, enjoying sector leadership and well-protected profits. They are borne aloft on a wave of popular support. Anyone not yet a customer feels behind the times. These winners tend to be acquisitive: if they spy a competitor they will try to absorb. An example is web giant Tencent. More than two thirds of Chinese people use its messaging app. With a ROIC of 19.5% and a WACC of 13.4%, Tencent’s moat has been built by the network effect.
Some companies can offer their products at a lower cost than competitors, whether because of location, a unique process, or scale. Brazilian car-rental company Localiza, for example, has its foot firmly on the throats of competitors thanks to its dominant position: it can buy cars more cheaply than they can. Any company daring to threaten it would need deep pockets, and might be met by a price war. Localiza continues to grow the market, and although this means it is not as profitable as it could be, its dominant position gives it a clear cost advantage.
We all know the feeling: sometimes it’s just too much trouble to change. When was the last time you switched your bank account, for example? Companies can build winning moats from customer inertia, which may not be laziness, but for perfectly good business reasons. Advantech, the Taiwan-based industrial computer supplier, benefits from the high costs customers would face were they to switch. Imagine halting a factory production line to replace Advantech’s embedded systems! Advantech earns higher margins than many larger but less focused computer suppliers, such as Asus (also based in Taiwan). Advantech has a ROIC (19.0%) almost double its WACC (9.9%), thanks to a moat that is hard to escape. (The numbers for Asus are ROIC 5.0%, and WAAC 8.7%: no moat at all.)
Intangible assets provide strong weapons with which to forge moats. Abu Dhabi National Oil Company for Distribution is protected by the intangible asset of regulations, under which it is the sole retail fuel operator in Abu Dhabi. Its local monopoly moat gives strong profit protection: ROIC is 20.8% and WACC 5.4%. Other forms of intangible asset include technological know-how or intellectual property (examples are Taiwan Semiconductor Manufacturing Company, Samsung, and Sunny Optical, which makes camera modules for smartphones) and brands (such as Chinese fashion house JNBY).
Source of ROIC and WACC data: Bloomberg as at 09/08/2018.