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A Reader’s Question on Niche vs. Moat
I found this blog post interesting: http://www.whopperinvestments.com/acmt-quality-at-a-discount. It raises an interesting question that I have thought about some: What is the difference between a moat and a mere niche? Can a niche be a moat?
Here, you have a local surety company that specializes in issuing bonds to construction companies with bad credit that the big boys aren’t interested in. Does that represent a moat of sorts in that the big competitors are not interested in this segment of the market? Or is it just a very narrow moat (if a moat at all) because the big competitors could move into it very quickly?
I looked at a finance company which specialized in subprime lending for used cars. It was very similar in that the big banks were not interested because it took too much work. The company was able to drive very high returns on capital. Again, moat or mere niche? These businesses are service businesses so while there might be local economies of scale, they won’t be very dramatic.
I think the advantage lies in the fact that big competitors have pursued mass market strategies based on easily repeatable processes with little customization. Perhaps they will leave this niche alone forever as it would not be particularly profitable. Or, they could train their sights on this niche and crush these ants. In the end, I would say this niche strategy provides a very narrow moat.
My Reply: From Greenwald’s Competition Demystified: When a company has stable market share, profit margins and excess cash generation with earnings power value above replacement/asset values–there is evidence of a franchise or MOAT. A company may have cyclical earnings, cash flows and margins but have a moat like Deere_VL. It may operate in a subset of a larger market like WD-40 (WDFC_VL) does in house-hold lubricants. WD-40 has over 90% of the US market in house-hold lubricants but then dilutes its returns somewhat by diversification into cleaners. It dominates a niche which gives it a high, stable market share with high, consistent returns.
You can have a niche business that fills a need and where you have a lower cost structure than larger competitors, but it doesn’t mean you have barriers to entry–see example of logging business below. Typically a niche business with a moat can’t grow beyond its boundaries without diluting its franchise or shareholder returns.
In a financial services business, the competitive advantage–if there is one–comes from better market intelligence and/or cost structure than a competitor. So, for example, you are lending for taxi medallions in the NYC market and you are the largest owner of taxi medallions then you have an informational advantage both in assessing the market, the borrowers and for acquiring new clients. Note this company: Medallion_AR.
GREAT QUESTION. I am sure other readers know more.
A Logging Business Niche Opportunity
From Aaron Esch, former About.com Guide
Horses and a Portable Sawmill
Horse Logger Tim Kendall
Sometimes all it takes is a little creativity and a willingness to think outside the box to find a new niche in an otherwise crowded industry. If you would like to start a small one or two-man logging business consider this approach.
There are millions of board feet of good usable timber that is passed by everyday by the big sawmills and logging companies. This is a tremendous opportunity for you as a small logging company. You can go into a small wood lot and harvest timber because you don’t have all the overhead that the big guys do.
Definition Wikipedia:
A niche market[1] is the subset of the market on which a specific product is focusing. So the market niche defines the specific product features aimed at satisfying specific market needs, as well as the price range, production quality and the demographics that is intended to impact. It is also a small market segment. For example, sports channels like STAR Sports, ESPN, STAR Cricket, and Fox target a niche of sports lovers. Every product can be defined by its market niche. As of special note, the products aimed at a wide demographic audience, with the resulting low price (due to price elasticity of demand), are said[who?] to belong to the mainstream niche—in practice referred to only as mainstream or of high demand. Narrower demographics lead to elevated prices due to the same principle. So to speak, the niche market is a highly specialized market aiming to survive among the competition from numerous super companies. Even established companies create products for different niches, for example, Hewlett-Packard has all-in-one machines for printing, scanning and faxing targeted for the home office niche while at the same time having separate machines with one of these functions for big businesses.[2]
In practice, product vendors and trade businesses are commonly referred as mainstream providers or narrow demographics niche market providers (colloquially shortened to just niche market providers). Small capital providers usually opt for a niche market with narrow demographics as a measure of increasing their financial gain margins.
Class Notes (Several readers have asked me to post in one place)
Greenwald_2005_Inv_Process_Pres_Gabelli
Class Notes #1 Introduction to Value Investing for Special Situations
Sealed Air Case Study_Handout Sealed Air 1998 10-K Greenwald_Class_Notes_6_-_Sealed_Air_Case_Study
Hudson General Case Study_Read this First
Valuing Hudson General and Analysis
Greenwald Class Notes 5 – Liz Claiborne & Valuing Growth(2)
Class Notes #1 Introduction to Value Investing for Special Situations
Class Notes #2 Intro and Duff and Phelps Case Study
Class Notes #3 Institutional Investor on Value Investing and Lear
Lear 10K 2005 for Class #3 and Lear 10K 2006 Class #3
Class Notes #4 Investor buying distressed Tech Company
Class Notes #5 Review of valuation exercises and how to present an idea
Complete notes on Special Sit Class Joel Greenblatt
Case Study – Munsingwear Is Value Investing Dead_Pzena
Chapter 20_Margin of Safety Concept
HAVE A GREAT WEEKEND!
Insurance is an interesting beast – I’ve spent a lot of time studying it over the last year, and so I’ll chime in with a few thoughts:
1. Most insurers can be replicated in theory. There are nearly no barriers to entry, because with capital, loss cost data, and employees, you’ve got yourself an insurance company. Getting business in the door is easy too, because you just have to offer the right commissions for agents and the right prices for policy purchasers.
This is why we typically will see insurers bounce around the 1x P/B multiple. If returns are high, someone will create a new insurer, and they’ll steal employees from competitors. (Grab a VP, and they’ll bring 4-5 people along, etc.)
2. Animal instincts and over confidence (Read Seeking Wisdom by Munger) should lead it to typically having too much capital, and in a business without barriers to entry, this means we will wind up in a pretty bad position right from the start.
3. Those animal instincts lead people to try and tackle the profits of all the insurers, however one important characteristic should be kept in mind: You don’t know your Cost of Goods Sold until much later. Sometimes this is just 1 year, sometimes it’s 10 years, depending on the policy you write. Depending on the exposure, you may never be entirely sure if you just got lucky, or if you were actually right.
4. The result is that our animal instincts lend themselves to growing. We’re supposed to mate a lot, because our genes haven’t yet adapted to the technology, consistent food supplies, etc. that we have access to. Because we don’t know our COGS, this is actually a very important thing. This means that we will end up with periods of time when people will be irrational, and we should back off. Looking at history, 90% of the insurers around will likely be irrational. (Just my own estimate, without any real data) This is something that won’t change – if we stop having alcoholics in society, then you should worry that all insurers will become intelligent.
5. Why does this occur? Well, everyone loves to focus on revenue, which is where they first look for growth. I would argue that on occasion… value investors don’t give enough credit to revenue. I think it’s a great measure to look at, because it really tells you how much consumers want the product you have to offer. If you don’t have revenue, your net income probably doesn’t matter. Therefore, most boards are going to set compensation to at least be partially based on revenue growth. After all, who wants to go back to their country club and talk about how they shrunk the business 50%?
6. Now that we’ve established what the issues are, let’s look at some insurers who do things in a unique manner, and why they can’t be replicated:
Progressive – if they don’t like you ask a prospective policy holder, they will give you quotes with competitors. How would you feel if you walked into WalMart and they sent you across the street to KMart? Very few managers have the guts to do this. Progressive does it on their website. Others don’t do this for the most part, because they couldn’t even imagine the thought of not selling to a customer who wants their product. This allows Progressive to be picky, and their “moat” is purely psychological, yet will be hard to replicate.
Platinum Underwriters – They’ve shrunk their revenue nearly 50% over the last 3-4 years, and then bought back stock with it. They seem to understand why insurers typically trade around book value (no barriers to entry), and so when they trade at a 30% discount to book, they are very well aware that they either need to write policies with 30% profit margins, or they are better off shrinking the business and buying back stock to increasing the intrinsic value on a per share basis. No one else is going to go back to the country club and brag about shrinking their business.
USAA – With gold/diamonds/etc., we find that exclusivity is a huge deal. Otherwise, what value does jewelry provide? Someone could argue that a banana feeds people and so it provides more value. Well, the exclusivity might determine why it continues to be bought. USAA earns more profit than others for many reasons. One of those reasons, in my opinion, includes exclusivity. Because you have to meet eligibility requirements to insure with them, it’s like being in a special club. People don’t want to leave it – it’s exclusive. Further, because of this, they have very low turnover with customers, and because of this, they don’t spend much on advertising, and because of this, they pass along lower costs to the consumer, which further reinforces their decision to stay on.
The surety insurer that the writer asks about is one where I would look at how much he is paying relative to book value, how he feels about reserves, but then spend most of the time judging management. Don’t read their marketing group’s annual report – use the 10-K’s and look at how they allocate capital. It should be clear if they are worthy of your trust. There are enough good companies out there, so let it go if it isn’t obvious. The writer is spot on that it’s easy for someone else to come into their market. Consider looking at distribution (GEICO has a huuuuuuuge moat here), their P/B multiples in the past and compare it to when they repurchased shares, understand management incentives, look at how they scale revenue up/down, etc.
If we think about banks… a CEO who would have told his loan officers to hit the golf courses in 2005 until 2008 would have been one of the best performing CEO’s of a bank. This level of rationality is super rare. I’m sure they would end up writing some loans, so they might have to work a day or two every week, however they would have been better off sitting idle. Insurance is no different.
Personally, I focus on culture and management’s historical actions when looking at an insurer. I don’t think there’s been any way that I could identify an insurer and say that “Wow, these guys have a niche in XYZ, or wow, these guys have such good pricing capabilities because they charge 18-24 year olds 2% more than others.” I’m probably pretty clueless for a whole ton of insurers and so I just stick to ones where I have an understanding of their culture. That’s what I can focus on – I count on the managers to handle my money well.
One last thing – if the management of the surety insurer is good, that’s all that matters. If you buy below book value, and competitors start coming in on their territory, they should scale back their premium while pricing is irrational, and could potentially begin liquidating. In that case, you make money if they stay in business, or if they see competition. In reality, managers like that don’t need to close up shop – their level of rationality will pay off huge most likely if you can sit tight.
To people reading… if anyone has ideas on how to analyze insurers who write pretty long tailed policies, I’d love to hear what you have to say. Again, I stick to culture, however I haven’t felt comfortable with them even with that understanding. Buffett has a medical malpractice arm and so I’m guessing he has learned how to judge the performance of a manager there, and I’m really curious what he looks at. (This matters so that when there is a horrendous year, I know whether it was due to bad process or bad luck.)
In summary – I think insurance is truly about management and the culture they formed. They can join the crowd and get sucked in by their animal instincts, or they can be deliberately slow and cautious, and excel over time.
Nice post, just a quick comment on Progressive. The practice of quoting competitors is interesting, but I’m not sure its gutsy. If you think about it, its actually a really savvy insurance practice. They’ve picked up where their competitors are pricing risk aggressively relative to Progressive’s assessment of risk and basically sending their competitors the potential problems.
I agree with you – it is very savvy. I think it is counter to human psychology though, because it requires the ability to tell a customer to go away, and I don’t know of other insurers who do this.
Dear Dr. Gupta:
Great post. I also suggest looking long and hard at the company’s history and policy of reserving. A company involved in run-off insurance that explicitly says (and seems to) reserve conservatively is Enstar Group, Inc. (ESGR).
Thanks John. They do look interesting, especially because they’re in the area of taking things other don’t want – probably at least partially due to how it impacts their customers’ accounting, and ultimately, executive bonuses. Taking those assets (for those reasons) would be one of the easiest ways to make above market _economic_ returns.
They do seem conservative on the whole – the thing that I wonder about with every insurer is how to judge these longer term liabilities, because they have certain macroeconomic expectations built into them. If inflation were to pick up, their reserving could show them being under reserved. In reality, they may have been doing it properly based on what was commonly expected. I will have a hard time determining how to judge them the day things turn negative because of that. I think there might be some who hedge their interest rate risk, however it seems that Fairfax Financial (Prem Watsa) hedges against deflation – which is the opposite of what I expected.
In general, I look at a company like Carmax, and I can articulate why certain things can occur, and I won’t “punish” management for it – if used car prices drop by 10%, and they carry $1B of inventory at all times, I will expect them to take a $100M pre-tax hit, and I won’t mentally penalize them for it. The same goes on the way up. Because there are expectations built into long tailed liabilities, I don’t really know how to judge them… yet
As you said, I need to take a long and hard look at their reserving policy. I’m guessing that the best route is to print out a few 10-k’s (spaced apart by a few years) and just start studying what happened, how things worked out, etc., because maybe my concerns don’t even exist with a firm like them.
John, Your reader can also learn by looking how other great investors have viewed a particular industry from experience. Here is Leucadia in 2009-10 on Sub-prime auto lenders:
AmeriCredit Corp.
At December 31, 2009, we owned approximately 25% of the outstanding common shares of AmeriCredit Corp. (NYSE: ACF) for an original cost of $418.6 million. ACF is an independent subprime auto finance company that purchases and services automobile sales finance contracts, typically for consumers who struggle to obtain traditional financing from a bank or manufacturer’s captive finance company. At December 31, 2009, our investment in ACF is classified as an investment in an Associated Company and is carried at fair market value of $639.8 million.
For almost 20 years, we owned a similar business and as a result carefully followed ACF. ACF’s large volume and efficient processing and underwriting abilities made it a fierce competitor.
In 2004 we exited our business, deploying our capital elsewhere, rather than fighting a pyrrhic war with larger, more efficient competitors, some of them willing to accept puny returns.
But, we retreated with our eyes open. We observed that in previous recessions ACF suffered
its share of poor credit performance; however, when a recovery was underway ACF made larger profits by being able to select more credit worthy customers and to charge more for loans.
Although the current recession has been much harder and deeper than we anticipated, ACF performed as expected. ACF is acquiring more credit worthy customers and is able to charge higher rates. Credit performance is improving. Securitizations, which were completely frozen until the Federal Reserve’s TALF program got rolling, have come back to life. During 2009, ACF issued two separate TALF-eligible securitizations, one of which had investors who benefited from the TALF program. All indications are that ACF has adequate liquidity for the
benefited from the
foreseeable future.
5
As in much of life, ACF’s secret to success is discipline. Currently, competition has lessened and ACF can earn a fair return for its risk. Eventually, banks and other folks will come rushing back into the market, margins will fall as evaluation of risk becomes, yet again, ignored and loan volume will become the sole focus of competitors as a means to impress the Stock Market. When that day comes, we hope ACF will eschew volume, efficiently harvest its portfolio and watch the lemmings as they launch themselves off a cliff. Then the cycle will begin anew.
We have a great relationship with, and respect for, the management team. We believe they are
the best in the industry.
And then in 2010:
• In October 2010, we sold all of our common shares of AmeriCredit in a cash merger with General Motors Company. Leucadia received $830.6 million for the shares that we spent $425.8 million to buy. We began purchasing the stock on October 19, 2007 and sold on October 1, 2010. The $404.8 million gain resulted in a compound annual return(IRR) of 29%.
I may have forgotten to add that LUK sold because it took very little time for the large banks to come back in to the market and drive down margins/returns again. Just as a disciplined insurance underwriter would slow down writing new business at unporfitable rates, LUK exited their position rather than wait for same to hot their investee.
This is exciting to hear. I wasn’t aware we had such rational lenders out there to be quite frank. Thank you for sharing this.
Thanks, Peter, for sharing that.
I noticed the three links on logging with horses do not work. Here is one of them: http://csinvesting.org/lr/logging_with_horses/1356357/1/
Just ignore the links.
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