Tuesday, February 24, 2015

CNY Post - Business Moats. Must Read!

Investing is about finding discounts (or margin of safety). The discount is the difference between the intrinsic value of the company, and the current stock price. Intrinsic values of companies do not change daily. Good companies can grow or compound value. Bad firms destroy value. So the trick is to find good companies, and buy them cheap or at a fair price. They only get really cheap during financial crisis. In normal times, like now, we have to look hard. It is not easy but not impossible.

Good companies have what we call business moats or economic moats. They keep building their businesses around certain factors that keep competition at bay. Business moats are not easy to identify to many laypeople. We would usually think that technology is a moat, or innovation or perhaps government support. But these are usually not moats. They can keep competition at bay for a while. But they are not sustainable. Especially government support or policies which can change in a wink.

True business moats that I see time and again are:

1. Brands
2. Scale
3. Eco-system
4. Switching cost
5. Distribution

Technology is usually not a moat because it is usually copied. Some guy invents a new technology, say, the electric vehicle. For 100 years we pump petrol to make cars move. No longer do we need to visit gas stations to fill up our cars for them to run. Then we see 10 other manufacturers making electric cars. Tesla's moat is definitely not that it makes cars that runs on batteries. It's gonna be something else (if they succeed though, they are still burning cash). But that's topic for another day, let's talk about innovation first.

I think innovation comes together with building brands. By itself, innovation is not enough to defend a business. Innovation is also always copied. But if a strong player has a strong brand, by further strengthening it with innovation, then the business moves towards impenetrability. We discussed Colgate and Swatch before. It’s also the same with Kao (in laundry detergent: Attack & Attack Neo), Diageo (Johnnie Walker) and Reckitt (Durex condoms) etc.

Economies of scale is very important, hence investors always look at market share and the industry structure. If the market leader grows to be a certain size, it is very hard for any competitor to replace it. As the largest player, it will also has the lowest cost of production, the biggest spending power, the attraction for talent to join. It is very powerful. When a certain company has over 40-50% market share in certain products, usually its scale is so huge that it's impossible for any competitors to fight them head on.

Eco-system, switching cost and distribution are similar. By building a network that supplement the business, it makes it hard for customers to leave or for competitors to enter. Facebook built an eco-system locking in the world, our friends, families are all on Facebook, we cannot switch easily. Alibaba also has a strong eco-system with its taobao online shopping mall and now all sorts of stuff including a money markets fund and Alipay and taxi apps etc. Honda’s strong distribution and sales network in motorcycles is why it flourishes in the emerging markets. When your bike breaks down, you need the service guy to be round the corner, imagine buying a Korean bike and nobody can service it! Johnnie Walker/Diageo is also sold in over 100 countries, since 100 years ago. We can find those small bottles of Johnnie Walker in a remote village in Vietnam or Africa for that matter. Diageo’s distribution network cannot be easily replicated. In fact Diageo has brand, scale and distribution, which makes its business moat so huge that it's mind boggling!

I do not think the moat list ends here, there will be other moats. It takes time and experience to understand them. Warren Buffett took 50 years. Bros and gals, we are just starting here... As we learn about these business moats, it helps us become better investors and better thinkers. I learnt by reading daily, newspapers, annual reports, books, magazines. This is a hobby that requires you to read a lot. If you like to invest but not reading, something doesn't gel here. Also, screens are killing our eyes, so nowadays actually I would prefer hard copies. Trees or your eyes. Your choice.

But actually, the most important thing in investing is buying with a margin of safety. The 30-40% discount. Even if you have identified the best businesses with the best moats, it will all come to waste if you bought it at a high price. The high price could have factored in years of growth so your return is bound to be miserable. Say a great business can compound at 10% per year. But you bought it at say, 40% over-valuation, it takes 4 years for catch up. So even if you hold it for 5 years, you would only have earned 10% over 5 years. That's 2% per year. That's miserable return, you might as well put in fixed deposit.

To buy at good discounts is not easy. Hence Buffett mentioned that great companies should be bought at fair value. i.e. if the company compounds value at 10%, then just buy at par, no need discount.  Bcos every year it will deliver you 10%. To get it at a good discount, usually it only happens once in a long while, when markets crash big time. Things would look so bad that buying stocks would be the last thing on your mind. At that point, it takes courage to buy when fear grips the whole world, and the stock markets. Hence, "be greedy when others are fearful."

Well it's Chinese New Year or CNY, it's good to be a bit greedy, just a bit and just for these 15 days.  Happy CNY to all! Huat Ah!
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