#066 Investing In An Age Of Disruption, Common Sources of Competitive Advantages, Insights from Nick Sleep's Latest Letter
“All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.” - Arthur Schopenhauer
Hi, Welcome to the 66th Edition
Brief Overview of What We will cover in this Issue
Detailed Key Takeaways from the book I am reading Currently
Investing In An Age Of Disruption
Common Sources of Competitive Advantages
Short-term vs long-term (Nick Sleep)
Small Investing Bits (Unifi Capital)
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The Investment Checklist (Part-2)
In what foreign markets does the business operate, and what are the risks of operating in these countries?
it has become increasingly important to learn more about the foreign markets in which a business derives its earnings.
When a business first enters a foreign market, revenues may grow quickly, which signals to investors that the product or service will be successful. Most management teams will highlight this revenue growth in their annual reports or other financial filings. It is dangerous to project these high initial growth rates into the future,
To determine whether a business will be successful in a foreign market, you must determine how committed a management team is to growing in a foreign market.
You need to understand if the management team is prepared to commit enough resources to sustain their growth in that particular market. Just as in domestic markets, the more customers are comfortable and familiar with an existing product or service, the more difficult it is to persuade them to change brands.
To understand how committed the top executives are to growing in foreign markets,
you need to answer the questions discussed in the next subsections:
How long has the business been operating in the foreign market?
Is the business investing in research and development (R& D) to adapt its products to the specific tastes of the customers in a foreign market?
Has the management team assigned a specific regional manager to emerging markets?
Is Revenue Growth Translating into Profit Growth?
Most businesses break down their revenues and assets by geographic region in the footnotes to the 10-K, but few will disclose enough information to allow you to assess whether the business is increasing its profitability in foreign markets. If the company does not provide adequate information, such as the operating profits earned from certain geographic regions, be cautious. This means that management is probably not generating excess profits in these foreign markets.
What Are the Risks to a Company’s Foreign Earnings?
In other words, there is a risk that a business will lose money in a foreign market due to external factors.
Country Risks You need to understand the risks of doing business in each of the countries where a business earns more than 10 percent of its revenue.
Be careful extrapolating the past success of a business in a foreign market into the future. You need to consider that government policies for foreign investment can easily change.
You can often learn more about the risks of operating in a particular country through the World Bank, which publishes a Doing Business Report, which ranks countries according to the ease of doing business in them.
Currency Risks One risk to international earnings is changes in the currency rate. For example, if you have a plant in Canada that manufactures a product and sells it to the United States, then the costs for the plant are in Canadian dollars and sales are in U.S. dollars. If the U.S. dollar depreciates against the Canadian dollar, the margins of the business will decrease because each dollar is now worth less when converted to Canadian currency.
Most businesses will report the impact of changes in currency in their public filings. Most of the time, the impact is low due to hedging.
If a business reinvests the revenue it earns in a foreign country back in the same currency, then it will not need to hedge. This is often referred to as a natural hedge.
Understanding the Business— from the Customer Perspective
Customers are the lifeblood of a business. In fact, the quality of a business is determined by the quality of its customers. At the end of the day, they are the stakeholders who determine the fate of a business. If customers are not satisfied with a business, they will eventually find alternatives, or an entrepreneur will create an alternative if one does not exist. The more you can understand a business from the customer’s perspective, the better position you will be in to value that business because satisfied customers are the best predictor of future earnings for a business.
One of the main pitfalls in researching a business is viewing the business from your own perspective, instead of viewing the business from the customer’s perspective. This is one of the areas where investors make the most mistakes.
Most investors allow their personal likes and dislike to influence their analysis of a business. If you really like Nike tennis shoes, for example, then you will look at Nike’s business in a more favorable light.
What you personally like is irrelevant to investing.
To begin thinking like the customers and to understand how they interact with the product or service on a day-to-day basis, you need to interview real customers.
Is the customer base concentrated or diversified?
A business that earns its revenues from a diversified customer base has less risk than one with a concentrated customer base. If a business is dependent on few customers, then these customers can influence the price a business charges for its goods or services, and the loss of one customer can have severe financial consequences.
What is the customer retention rate for the business?
Determine whether a business is retaining its customers or if it is constantly turning them over (churning them). The longer a customer is retained by a business, the more profitable that business becomes.
A loyal customer base generates more predictable sales, which can improve profits.
In the long run, businesses that spend time cultivating long-term relationships with their customers are more likely to succeed.
The customer retention rate is the most common metric for tracking customer longevity.
Unfortunately, you will only be able to calculate or track customer retention rates for certain types of businesses, such as those that earn recurring revenues from subscriptions or franchise fees.
You should also find out if the business is making investments to retain customers. You can often ask the investor relations department of a business this question, or you can gain insights by reading historical articles written about the business.
If certain customers are more profitable because they are easier to attract or easier to retain, look for high-quality businesses that focus on these more profitable customers.
How Does Management Stay Close to Customers?
Read the biographies from the proxy statements to determine how long the CEO or top executive officers have served a particular customer base.
You will often see articles written about how businesses connection to customers. The understanding their custom CEOs stay close to their at the business you are and outdoor retail chain stay close to customers.
To what degree is the customer dependent on the products or services from the business?
you need to determine if the product or service is “need to have” or “nice to have” for the customer. The more a customer needs to have a product or service, the less the earnings of a business will fluctuate. The more discretionary a product or service is, the more earnings will fluctuate.
Do not make the assumption that a discretionary business or industry will always lose sales in tough times, however. For example, many luxury retailers— such as Louis Vuitton Moët Hennessy or Compagnie Financière Richemont SA, which owns Cartier, Montblanc, Alfred Dunhill, and Van Cleef & Arpels— were thought to be sensitive to business cycles, and their stock prices fell when the recession began in 2007. However, the stock prices of these two companies quickly rebounded as their core customers, who are ultra-wealthy, continued their spending habits, and sales did not drop as much as was anticipated.
Evaluating the Strengths and Weaknesses of a Business and Industry
It’s also extremely important for you to analyze the strengths and weaknesses of a business in the context of its competitive environment. The stronger the business’s competitive position, the higher the probability that it will be able to sustain its current earnings as well as grow them in the future.
If the industry is difficult or unprofitable, you’ll find it harder to make money on your investment, even if you manage to pick the best company out of tens or hundreds of others in that industry.
Finally, you want to understand how industry supply chains work. Good supplier relations can improve the efficiency and reliability of source goods, so I’ll walk you through how to evaluate supplier relationships, supply chain efficiency, and sources of supply chain risk.
Does the business have a sustainable competitive advantage and what is its source?
is critical to determine whether a business has long-term protection from competitors,
If you are unable to determine whether a business has a sustainable competitive advantage, then it is difficult for you to commit to a long-term investment in a business.
Therefore, when you’re analyzing a business, you should always ask these two questions:
How easily can someone else copy or replace this advantage?
How quickly might they do it?
A business that has a large set of investment opportunities “inside the moat” has a much higher intrinsic value than a business without competitively reinvestment opportunities because the former advantaged compounds cash flow at a very high rate, whereas the latter is forced to use cash for sub-optimal opportunities.
Microsoft’s moat, for example, may give an investor a reasonable degree of confidence that the return on capital of the core business will persist, but it adds very little value due to the maturity of the company’s core business— cash that is generated just sits on the balance sheet, or is invested “outside the moat” in areas like search (i.e. Bing).
Common Sources of Competitive Advantages
Dorsey distills the sources of competitive advantage into four categories (Dorsey combines brand loyalty, patents, and regulatory licenses into one category titled intangible assets) which I have broken down into six categories:
Network economics
Brand loyalty
Patents
Regulatory licenses
Switching costs
Cost advantages stemming from scale, location, or access to a unique asset closer look at each source.
Source #1: Network Economics:
One of the strongest sources of competitive advantage is network economics. If a product or service becomes more valuable if more customers use it, then the business benefits from network economics.
More customers again resulted in more connection and access, and more value.
Can you guess which was the first third-party charge card developed in the United States? Most of you will answer American Express, Discover, Visa, or MasterCard, which together represent the majority of current spending on credit cards. However, the correct answer is Diners Club, which spawned a new industry when it launched the third-party charge-card business in the 1950s. It possessed the highest number of both merchants and users; in fact, it was so successful that at one time, American Express even considered selling its charge-card business to Diners Club!
Source #2: Brand Loyalty
A brand can give a business a tremendous advantage over competitors when customers remain loyal to the brand and when a business can charge a premium price for the brand.
Louis Vuitton will destroy overruns rather than sell them through discount channels. In contrast, Gucci discounts its inventory more frequently. Yves Carcelle, chief executive officer (CEO) of Louis Vuitton, says, “We’re never on sale. All the rest discount. Us, never. When a customer invests in one of our products, they don’t expect to see it discounted three weeks later, so we don’t do it.”
Source #3: Patents
Patents can be a source of protection because they legally protect the products or services of a business from competitors over a 17- to 20-year period.
Source #4: Regulatory Licenses
Regulatory licenses and approvals can also create sustainable petition.
If the source of advantage is regulatory, spend your time closely monitoring legislative threats from the entity that regulates it, whether it is in Washington or in state or local government offices.
The competitive advantage’s strength depends on how much power the regulatory entity has over controls the prices a business pricing. If the regulatory entity can charge customers, then the competitive advantage is weaker.
Businesses regulated at the federal level have more risk in one respect, which is that a single rule change can affect the entire business.
Source #5: Switching Costs
Why would you not buy a cheaper product of the same quality or a better product for the same price? The answer is that there may be an additional cost associated with changing products or a reduction in the benefit you stand to receive. These are often called switching costs,
The strength level of switching costs is determined by how embedded the product or service is with the customer or the amount of training needed to use it.
The savings of switching to a lower-priced competitor would be outweighed by the additional training time. Also, because many of its customers are traders, the benefit of switching to a less costly service to save maybe a few thousand dollars a year is small in comparison to the size of the transactions they are making.
Source #6: Cost Advantages
Cost advantages include such factors as economies of scale and advantageous locations. The more structural a cost advantage is, the more sustainable it is. For example, lowering costs by moving a call center to India will help a business, but most of its competitors can narrow this advantage by doing the same.
Economies of scale are a more structural kind of advantage. As a business with fixed costs grows, it is able to take advantage of lower per-unit costs. This way, it is able to charge lower prices for its products or services compared to competitors.
Obtaining a Cost Advantage through Industry Consolidation In large, fragmented markets, especially those that have become commoditized, you can often see businesses with low-cost advantages building market share. The higher the market share, the more customer choice is limited, which gives the surviving dominant players an advantage.
Obtaining a Cost Advantage through a Good Location Whenever a business has a geographic location that competitors are unable to easily duplicate, this can give a business a cost advantage.
The Best Kind of Sustainable Competitive Advantage Is Structural
When customers have limited choices in the products or services they can use for extended periods of time the competitive advantage is likely structural.
The best way to identify a structural competitive advantage is to view it from the perspective of customer choice: Does the customer have limited products or services to choose from, or does the customer have many choices?
Structural advantages are typically the most sustainable advantages. For one thing, the more a competitive advantage is based on structural characteristics, the less the business depends on such factors as management execution.
These are the business to hold long term
Why It’s Hard to Find Businesses with Sustainable Competitive Advantages
Technological advances have shortened the lifecycle of many competitive advantages.
Competitive advantages are less sustainable when they are affected by changes in technology or if they are in rapidly emerging industries.
The Internet has reduced the sustainability of many competitive advantages. For example, newspapers lost most of their classified advertisers and the large percentage of profits they represented to low-cost Internet sites.
Beware of Businesses that Were Simply at the Right Place at the Right Time Too often, investors look at a business’s past success as a result of a competitive advantage, when they should be asking why a business has a competitive advantage and if there are certain conditions that created it.
Most Investment Gains Are Made During the Development Phase, Not After As you are learning about the source of a competitive advantage, it is important to remember that the greatest gains in a stock are usually made as a business is developing its competitive advantage rather than after it already has developed one. For example, we all know that Wal-Mart has a competitive advantage, but investors earned the biggest stock gains as Wal-Mart grew and developed this advantage.
Ideally, you want to identify those businesses that are in the early stages of building a competitive advantage. It can take years and sometimes decades for a business to develop its competitive advantage, and it is difficult to see a competitive advantage building because in most instances, the business is losing money during that time.
The best way to distinguish whether a business is building a competitive advantage or wasting money is to monitor the number of customers a business serves.
The investments Amazon.com made increased the number of customers it served. In contrast, businesses that fail are those that continually spend money but do not increase the number of customers they serve.
Look for those businesses that continue to push product or service innovation by investing in research and development (R& D) or that are wisely spending marketing dollars to increase awareness of their products with superior value propositions or unique appeal.
Be cautious of those businesses that only imitate innovation. For example, Wal-Mart has always had cutting-edge information technology (IT) systems for retail. It was one of the first retailers to invest in barcode scanners to increase efficiency.
What Is Not a Sustainable Competitive Advantage?
It is important for you to distinguish a business’s competitive strength from a sustainable competitive advantage. If a business has good customer service, a quality product, and a knowledgeable workforce, those are all strengths, but those can often be duplicated.
Some strengths are more difficult to develop than others, such as having very knowledgeable employees, a strong employee culture, or an efficient production process.
Therefore, sustainable advantages include factors that are difficult to copy, such as accreditation, whereas competitive strengths include such factors as an easy-to-navigate website.
The best indicator of competitive advantage is a business’s ability to increase prices without losing customers.
Common Characteristics of Firms with Pricing Power
They usually have high customer retention rates.
Their customers spend only a small percentage of their budget on the business’s product or service.
Their customers have profitable business models.
The quality of the product is more important than the price.
Are Pricing Advantages Sustainable Rather than Temporary?
To determine if a business can raise prices, begin by looking at the Management Discussion and Analysis (MD& A) section found in the 10-K, and read management’s explanations for changes in the gross profit margin.
Finally, see if these price increases have translated into operating income growth, or if they have been used to offset increased expenses. To do this, compare the gross profit margin to the operating-income margin over a one- to five-year period. If the operating-income margin is dropping as the gross margin is increasing, then expenses may be rising faster than price increases.
Another method to identify pricing power is to calculate historical operating profit metrics.
In most cases, if a business has pricing power, it will disclose it. If the business does not disclose increasing prices, then it is highly probable the business does not have pricing power.
Look for price increases in the context of other indicators of pricing power: trends in profit per customer, pricing that doesn’t just offset increased costs and price increases that can continue for multiple years.
Examine Whether Pricing Power Is Found Throughout the Overall Business or Only a Segment of the Business
Some businesses have pricing power in certain products or services, yet not in the majority of the products or services they offer.
Technology Creates Price Transparency
The Internet in particular has helped create price transparency. In the past, some businesses were able to maintain higher pricing because it was more difficult for customers to compare pricing. For example, consider the changes in hotel room price transparency. In the past, customers relied on travel agents or had to call multiple hotels to compare pricing. In contrast, they now use online travel sites to do the same thing instantly.
Does the business operate in a good or bad industry?
Investing in the right industry is important because a large part of your potential rate of return is often attributable to the industry you are invested in, as opposed to a specific company you are invested in.
To get a deeper understanding of whether an industry is good or bad, compare the best companies to the worst within the industry.
Another Method of Industry Analysis— from Imperial Capital’s Steve Lister
Lister believes that finding the right industry is what counts most. Like many, Lister believes that your chances of picking a good investment are based more on the industry than on the individual company. He notes that if an industry is growing 5 percent to 8 percent a year, even if you do not identify the best individual company, your performance will still likely be good.
It is difficult for any business to outperform the industry for a long period of time.
Some of the questions on Imperial Capital’s scorecard include:
What drives the industry?
How do people compete within the industry?
What is the larger macro picture?
What are the industry trends?
What is the average cash conversion cycle for the industry?
What is the industry’s exposure to cyclical markets?
Does the industry have the ability to pass on price increases?
What is the volatility of demand from customers?
How has the industry evolved over time?
Understanding how an industry evolved will help you evaluate the business in the context of its competition, its operating environment, and the various other forces that shape it.
To understand the industry well, study its history over a long period (i.e., more than 10 years).
What is the competitive landscape, and how intense is the competition?
Competition does not increase the value of a business. Generally, more competition means more customer choice and less profitability.
Does the Industry Change Often? If the industry is one that is constantly changing, then it will be even more difficult to evaluate the competitive position of a business.
For example, if you are evaluating competitors individually in the technology industry, by the time you have analyzed most of those companies, the technology may change, which of course opens the door to a new crop of competitors you never considered.
How Do the Competitors Compete within an Industry, and How Could That Change?
Determine whether the competitive dynamics can change, and then construct different downside scenarios for the business based on those dynamics. Let’s look at each of these factors individually:
Competing on service: you should focus on understanding the reasons why one business has better customer service than another and whether that can change.
For example, if a new management team takes over a company that has poor customer service and if they make improvements, they may be able to gain market share from a dominant competitor.
Competing on price: You need to determine if the competitors within an industry have to constantly match each other based on price.
Competing by copying Be cautious investing in businesses whose management teams attempt to replicate the success of a competitor’s breakthrough products or profitable business lines.
Financial metrics to monitor to understand if an industry is becoming more competitive.
Take total costs and divide by the number of customers, transactions, or another metric.
As markets become more competitive, costs tend to increase.
To get more insight into the reasons for differences in profitability, read articles about the industry. Search for articles using search terms such as “auto industry profitability” to locate articles that are written about how the profits of an industry or certain businesses are changing over time and, more importantly, the reasons for these changes. (Very Useful)
As you learn more about each competitor’s strengths and weaknesses, you can begin to construct an ideal business using each competitor’s strengths.
Why Have Competitors Failed in an Industry?
Search for articles written about why competitors have failed in the industry. You will gain great insights into flawed strategies or operational missteps. (Another Useful Trick)
Excerpts and Learning from Articles/Blogs
1) Some Thoughts About Investing
Self-confidence as an investor comes from being comfortable with uncertainty. One of the few things we all have in common as investors — everyone from Warren Buffett to the Robinhood noob with $50 — is an irreducible level of uncertainty.
Once you let go of the illusion of control when it comes to the future, you focus on what you can control and let the chips fall where they may.
most bull markets last way longer than bear markets. Even if you’re right about a bubble call the timing is always the tricky part.
There is a thin line between genius and idiot. Geniuses are crowned during up markets. Idiots are revealed during bear markets.
Sometimes it happens to the same people.
It’s important to remember that bull markets don’t make you more intelligent just like bear markets don’t make you stupider.
Temperament is more important than IQ but it’s really hard to learn
Buy-and-hold has a higher probability of working for index funds than individual stocks.
Bear markets are temporary in hindsight but feel like they’ll last forever when they’re happening.
Some take longer than others. But patience has been rewarded if you’re willing to deal with the uncomfortable times in the stock market.
2) The Drift
Stock picking is ridiculously difficult and yet social media and business channels make it seem like a walk on the cake. Very few succeed to beat the Nifty in the long term but the fascination to make the cut remains.
Beating Nifty in itself doesn’t have to be the criteria to judge but if one is not fascinated by the process of investing, one should question the merit of trying to pick stocks in the hope that one will strike lucky and become incredibly rich.
very “Next Warren Buffett” has got blown over today because the risks required to be taken to become the next Warren Buffett have become incredibly high and that risk generally tends to mean that the chances of blowing up is higher.
3) Thinking about how to think: Short-term vs long-term
If a firm’s relationships with its customers is profitable and enduring, then that will provide the cash flow to pay a decent salary to its employees, a fair price to suppliers, a dividend to shareholders, the tax people can have their take and, crucially, still leave something to reinvest in new and better products
Zak and I wrote a fair amount about mistakes in the Nomad letters in which we discussed how mistakes often result from overweighing an apparent short-term win, without fully recognizing the consequent, long-term cost.
Firms that cut (vital) investment spending to “protect (this year’s) profits” or make acquisitions to plug revenue growth holes are borrowing from their future. Of course, businesses can be well run or poorly run, and charities can be well run or poorly run too, but, in our opinion, the distinction between good and bad is often synonymous with a long-term or short-term orientation: long-term good, short-term bad.
In the morning of the Berkshire Hathaway Annual General Meeting in Omaha, Nebraska each year, the firm shows a twenty-minute video containing clips from the last fifty/sixty/seventy(?!) years. In one clip, perhaps from the 1980s, the firm’s Chairman, Warren Buffett, is asked how he differs from other investors and he provides a one-word reply: “patience”. Zak and I may be biased, but we think that clip is quite a moment.
Patience is a product of confidence and trust**.
Without patience, there is no force preventing the drift toward short-termism, with all the moat-draining behavior that implies
4) Investing In An Age Of Disruption
1- Investors continuously underestimate the speed at which disruption transforms business and society.
2 – In an age of rapid technological change, we need to approach valuation, not with heuristics, but with new eyes.
3 – We should use diversification, not only to play defense but also to play offense. We don’t need a bad-ass, 3 stock portfolio to outperform the market
in an age of rapid technological change, we need to approach valuation with new eyes. Marcel Proust, the French writer who wrote the monumental novel In Search of Lost Time, said, “The real voyage of discovery consists not in seeking new landscapes but in having new eyes.”
We need to be dynamic and not get trapped using models that may no longer align with reality. If your model of the world is wrong, you’re not going to understand why something is happening, and you’re going to make mistakes.
While we have to be cautious around high-multiple, growth companies, we should not immediately dismiss a potential investment just because the multiple appears high, or worse, start working on a short thesis. As John Kenneth Galbraith said, “Faced with the choice between changing one’s mind and proving there is no need to do so, almost everyone gets busy on the proof.”
Let’s look at GEICO for a second, a company that has been highly disruptive to traditional auto insurance companies. Shortly after Warren Buffett purchased GEICO, he increased the company’s marketing spend. He did so because the unit economics of the business were so strong. But did that mean the company was suddenly worth less because expenses increased, and profitability temporarily dropped? Absolutely not. GEICO, in fact, became more valuable because the investment in marketing enhanced the present value of future cash flows. Of course, the investment would not have been accretive to intrinsic value had the economics of onboarding new customers been poor
It’s so convincing when someone says that a company’s market value does not make sense because it exceeds the market value of all its competitors combined. That sounds so rational, right? But if you look at history, that argument is often misguided.
Logically, whoever makes this argument is in effect saying that the market value of A, as stated in the numerator, should not exceed the market value of the competition B plus C plus D plus E, as stated in the denominator. But why not?
We know that a company’s market value should approximate the present value of future cash flows. Well, if a business is being disrupted, its future cash flows are likely to decrease while the cash flows of the disruptor are likely to increase.
And if you think about it this way, that means as the cash flows of the disruptor continue to grow, and the market value reflects that growth, the disruptor will be worth not just 1X the denominator but 2X, 3X and so forth as the incumbent players go out of business. After all, fractions increase exponentially as the denominator trends toward zero. Indeed, Apple was cheap in 2007 when its market value was just 1X its competitors combined
Investing in an age of disruption means that, more than ever, we need to think forward as opposed to backwards. We need to ask, “Where is the world ultimately heading?” And we need to break free from a “this makes no sense” snap judgement and approach valuation with new eyes, particularly as GAAP (Generally Accepted Accounting Principles) accounting does a poor job of representing the underlying economic reality of rapidly growing businesses. Put differently, we need to do deep work and not dismiss a seemingly high valuation without understanding the economics of the business and the underlying system structure. To do anything less is arguably irresponsible.
Bear markets provide us with the opportunity to diversify and provide added protection against unknown variables without necessarily having to sacrifice upside. That’s because in bear markets, there are usually lots of attractive opportunities in which to deploy capital.
Small Video Clips
Prashanth Jain on Value vs Growth (3:35 to 05:56)
➢ Chris Mayer on How to Pick “100 Bagger” Stocks | Equity Master
Chris Mayer's defensive approach and what he looks at in the balance sheet before buying stocks (17:55 to 21:24)
➢ Small Investing Bits from Unifi Capital
That’s it from my end for this week. Thanks for reading.
See you again next week!
Dhaval.
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