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Surviving Capitalism with Competitive Moats
Value Creation - Competition - Creative Destruction - Regression to the Mean
Hello, I am Nicolas Bustamante, and each week, I write about concepts and methods to build successful businesses.
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Capitalism is ruthless. It incentivizes hordes of entrepreneurs to compete fiercely to drive long-term returns towards the cost of capital for the benefit of customers. The merciless regression to the mean makes it hard to sustain a competitive edge over time. The average life expectancy for companies in the S&P500 dropped from 61 years in 1958 to less than 18 years today. The only way for a business to survive is to benefit from competitive moats.
In the long run, sustainable value creation is the difference between the return on invested capital and the cost of capital. The amount of value created depends on how much money a business can invest with a high rate of return. The best companies have a strong reinvestment capacity with good returns on investment. Quoting Buffet in his 1992 letters: "the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return." If a company has extensive investment capabilities and strong returns, the length of its competitive advantage period is the crucial question.
The company's significant returns will attract competitors causing the returns to move toward the cost of capital. It's a regression to the mean in which the company's returns tend towards the industry average. In this matter, all industries are not created equal. Some industries have fast regression to the mean, such as the food and beverage industry, while others are slower such as the banking industry. More importantly, the long-term average mean differs between terrible sectors such as real estate or utility and good ones such as software or professional services. The best industries have a significant long-term average profit and high barriers to entry, meaning a low entry rate into the market. In any industry, an Intelligent CEO can make a difference by creating and sustaining competitive moats.
Warren Buffet wrote: "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." Competitive moats make it harder for new entrants to attack the business. Quoting Warren Buffet: "We think of every business as an economic castle. And castles are subject to marauders. And in capitalism, with any castle, you have to expect that millions of people out there are thinking about ways to take your castle away. Then the question is, "What kind of moat do you have around that castle that protects it?"
Competitive moats are unique attributes a business use to sustain its edge against competitors. There are several moats that I like. A good brand, for instance, is a priceless advantage. Companies such as Coca-Cola or LVMH secure a hefty premium thanks to their brand. I also value network effects in which increasing the number of participants or data improves the value of the service. Facebook and Google have, for instance, so many users and data that it is tough to compete with them. Scale is also a good moat, especially in the financial and insurance business, because the cost per unit decreases while the operation scales. Intelligent CEOs know that it's not the size of the castle that matters but how defensible it is over the long run.
I like to analyze each business trait from the perspective of competitive moats. Everything a business builds or does is either for competitors: easy to replicate, hard to replicate or, impossible to replicate. A great company has many attributes in the "impossible to replicate" category. Great businesses build unique products and processes. A significant but easily reproducible business is a terrible business.
An excellent way to know if a company has powerful moats is to measure the ability to increase the price substantially. If a company can raise its price without losing customers, it is hard for new entrants to take over the business. The most potent form of that is a monopoly in which the company can raise prices by a lot. That's why Peter Thiel argues that competition is for losers, and entrepreneurs have to aspire to build a monopoly. Warren Buffet uses the pricing ability to assess the quality of a business. "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 10 percent, then you've got a terrible business."
Assessing a company's competitive moats and measuring its evolution over time is the best predictor of value creation and long-term success. A new and booming business doesn't mean much if it has no moats. Capitalism's creative destruction might soon send the company back to oblivion. Therefore, Intelligent CEOs should build moats and work to widen them over time. The goal should be to build a castle so hard to take over that the company will end up on the list of oldest companies ever created!
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