The twenty-minute time limit was to force you to concentrate on the key issue: Does this company have economies of scale? Because of it doesn’t, then growth will NOT help profitability. In fact, growth with losses financed by debt can be financially lethal.
Our 10-K reading skills and our analysis of competitive advantage. Despite how CRITICAL it is for an investor/management to determine and distinguish competitive advantages, structural advantages are often confused with outcomes or efficiency.
Competitive advantage refers to something specific–a structural barrier that prevents competitors from simply replicating the results of a successful business. It should not be surprising that the terms competitive advantage and barriers to entry are interchangeable.
Without barriers to entry, a business cannot long enjoy an advantage over competitors that will quickly do the obvious—enter. This process of new entry will hurt not only relative performance but also absolute performance, as competition for customers dampens revenues, and competition for resources raised costs.
FIRST MOVER ADVANTAGE
First, it is NOT a competitive advantage. But here is an example of having a first mover advantage. You and I are in a duel. We walk ten paces away from each other then turn and shoot the other. After three paces, you turn around and shoot me in the back–now THAT is a first mover advantage.
Scale not size matters
It is industry structure determines which categories are most likely to manifest themselves and in what form.
Size doesn’t matter, but scale does. Scale is a relative concept, not an absolute one. The benefit it bestows are relative to peers within the relevant competitive set.
Look at WD 40_VL the company has a competitive advantage in PRODUCT SPACE. WD-40 is the ubiquitous oil/lubricant that people keep in their tool-box/shelf/or under the sink. They own 90% of the lubricant market. However, they also di-worsify their free cash flow into hand soap and motor-cycle products. Now the stock is over-priced in my opinion. If management could sell off its non-competitive products, and then become a tontine (use free-cash flow to buy in all shares)–investors would flourish.
Having 2% of a 10 billion dollar market or $100 million in sales is probably not as profitable as having sales of 40% of a 200 million dollar market or $80 million in sales.
Scale matters most when fixed costs matter most relative to the business’s overall cost structure. With large fixed costs, the operator serving the most customers will have a significant advantage due to its ability to spread those costs over more unit sales. If the costs of a business were entirely variable and increased proportionally as it grew, there would no advantage to scale.The extent of the advantage is determined by how relatively important fixed costs are how relatively large the business is compared to the next competitor. Second, much of what is thought of as traditional fixed costs in school management—admin, school relations and lobbying, and even curriculum development—has a significant variable component.
Curriculum requires local customization. The two primary sources of fixed-cost scale in education generally are content development on the one hand and sales and marketing on the other.
Reading the 10-K
We jump to page 27: Selected financial data and see rising sales financed by issuing shares and debt. Yet costs are not declining as a percentage of sales. Ebitda is declining per student. 1999 revenues of $133 million almost triple to $376 million in 2001 yet operating cash flows decline from negative $17.6 to negative $29.3.
Remember the little red school house? Edison Schools has to provide services in a regional area. If they can develop density (or clustering as management mentions on page 16 under competitive strengths) in particular regions, then perhaps this company needs more time to show progress? To determine their success in implementing a “clustering strategy, the next pages to peruse are pages 13-15 where you can see where Edison is operating schools. Take a large state like Colorado. Edison has two schools in Denver and three in Colorado Springs. Washington, DC, a huge metro area, only has eight schools and on and on. Management will not be able to leverage their admin, curriculum and development cost over such a widely dispersed area.
Imagine running a carting/garbage pick-up service where you have 5 customers in Eastern Connecticut, seven in New Jersey, 4 in Texas, you would go broke just driving to the different customers. You would lack customer density in your routes, so your costs would be too high.
PASS! Then if the analyst had more time, he/she could look at management. He or she would uncover the ugly history of Chris Whittle. No mention of that in the Credit Suisse analyst 50-page report.
Studying competitive advantages like economies of scale, customer captivity, network effects, low-cost producer will pay-off. Practice reading case studies of success and failure will help you hone your skills.
The prior post asked you to guess the name and price that you would pay for this case study: http://wp.me/p2OaYY-2np (Part 1)
It is Annual:1974-annual-report-for-walmart-stores-inc. If you had paid the HIGHEST possible market price in 1974 or the first quarter of 1975 (after reading this annual report), you would have about 1, 300 times your money over 40 years not including annual dividends which today stand at about 31 times what you paid in the market (WMT 2014) through and despite wars, high inflation, double-digit interest rates, civil unrest, political changes and a mundane, extremely competitive industry, AND WMT’s stock price “UNDER-performing” the general stock market one-third of the time. See Wal-Mart 50 Year Chart_SRC.
Eat your heart out Buffett, Munger, Peter Lynch, and all other investing pantheons. The point is you would have made a lifetime fortune sitting on your hands for more than a third of a century. WMT is the pinnacle of an investment–a relentless compounding machine. Buffett said the goal of an investor is to put together a portfolio of compounding machines.
Well, Wal-Mart was the king of compounders; a company that could generate high returns on capital AND reinvest those high returns into similar high returns. As many of you know, it is easy to spot a company with high ROIC or ROE but how do you know if the company can grow and reinvest those high returns at the same high rates? If not, then that company should return the excess capital which it can’t reinvest to you through dividends or appropriate (below intrinsic value) stock buy-backs.
You could have paid any price in 1974, 1975, 1976, 1977, 1978, 1979 and generated over-15% annual returns. How would you know that WMT would keep growing with such high returns? What could you have KNOWN? What can we use for tomorrow’s investments?
AT Hindsight Capital (my firm) we always pick the Wal-Marts.
Joking aside, what is the point of this case study and what are the lessons we can use? Let’s be realistic, we may never find another “Wal-Mart” but at least we can study “perfection” or the best to grasp what principles to look for in a company and an investment. You could do worse than spend weeks or months studying the history of Wal-Mart. Start here Walmart.com/annual-reports and go to here: WalMart_AR. And read: Sam-Walton-Made-America.
You gotta at least see and hear excellence to know it.
Let’s get back to Wal-Mart. What is the essence–the key–to its ability to grow profitably for so long? What can you spot in the 1974 annual report that would have alerted you to its competitive advantage? In other words, follow Hannibal Lecter’s tutelage when analzing any investment: What is its nature? http://youtu.be/f33ieCWRWlI.
Here are two hints:
Sam Walton‘s passions included flying his own plane over the American countryside, hunting with his dogs, and sharing his good fortune with his family. But Walton will always be best remembered for his lifelong passion for providing low prices and good service to customers at Wal-Mart, his chain of discount stores that revolutionized the retail industry.
Walton did not invent the discount store when he opened his first store in 1962. But he did do something new. Wal-Mart introduced the concept of selling a large number of items at cheap prices to residents of rural towns—customers other discount retailers ignored. From that base, Walton expanded Wal-Mart across the United States and eventually reached into foreign markets, using the latest technology to keep costs low.
“I think I overcame every single one of my shortcomings by the sheer passion I brought to my work.… If you love your work, you’ll be out there every day trying to do it the best you possibly can.” Read more: Walton
The second hint is that you will not see the financial results of WMT’s competitive advantage in its GROSS margins but in its NET margins. WHY?
The answer to my questions can be found in Competition Demystified (Chapter 5) but don’t cheat yourself. Think it through. In fact, if YOU wanted to get a job at hedge fund, investment firm or even work for a major service firm, you could do a comprehensive study of Wal-Mart’s rise and semi-fall of its competitive advantage and then find a new company or industry (Auto-parts?) where the same factors are at work. Show what you can do while providing a study of value. You will stand out from all the Harvard and Columbia MBAs.
I will post in Part 3: Analysis on WMT next week. Meanwhile focus on what is important.
QUIZ: Discuss in a few words the mistakes made in these recent acquisitions in the newspaper business. If you wanted to develop an advantage in newspapers how would you do it. (Hint: What is the most profitable news magazine in the world–or close to it?)
How would you advise Bezos to enhance his purchase of the Washington Post?
…..So Ackman vs. Herbalife has no heroes. Both parties, in their own way, take advantage of the goodwill and trust that underlie capitalism. Herbalife recruits sales people with the knowledge–based on mathematical certainty but undisclosed to its recruits–that the vast majority will lose money. Mr. Ackman, for his part, has gotten rich betting against bad companies. One party is possibly immoral, the other party at best amoral. Who do you cheer for? –Mr. Karlgaard, publisher of Forbes (A Short Seller Takes on a Vitamin Vendor, WSJ Jan 4, 2013)
Yes this battle will be gruesome, bloody and long (perhaps) but our purpose is to understand whether Herbalife which–as of the last filing–sported franchise-like financials of high ROA, ROE and ROIC with growing sales. Copious cash flow. On the surface, the company seems to have a franchise. Why can’t other companies do the same thing. What barriers to entry are there? Product patents, customer captivity, economies of scale and scope, network effects, etc. This battle will allow us to understand what drove Herbalife’s success. Will it be fleeting or lasting. My bet is that Herbalife does NOT have a lasting competitive advantage.
The quote above by Mr. Karlgaard is disappointing because as a publisher of a business magazine, he should understand Mr. Ackman’s purpose. A good investor should invest in companies that will use owner’s capital wisely and should not invest or even warn against investing in companies that mis-allocate capital for the long-term. Short sellers are just as important as having a Warren Buffett in the market. An Ackman does more for future growth than any government program because–like him or not–Mr. Ackman is trying to take capital away from poorly managed, potential frauds, unsustainable businesses while allocating capital to companies that will use his investors’ capital beneficially. He may be proven wrong but that is for the market to decide.
UPDATE: MONEY SUPPLY EXPLOSION--We are now officially in double digit territory for non-seasonally adjusted 13 week annualized money supply (M2) growth. Here is the amazing ascent in growth over recent weeks: 5.1%, 5.6%, 6.6%, 7.1%, 7.5%, 7.8%, 8.2%, 8.4%, 8.7%, 9.0%, 9.3%, 9.6%, 9.9%, 10.7%. It is this growth that is going to fuel the U.S. economy, the U.S. stock market and commodities. www.economicpolicyjournal.com
Investing in Banks
I find investing in global banks like Bank of America or Citibank impossible because I have no way to value or understand their businesses. How much “shadow” banking do these entities engage in? I don’t want to find out the hard way. See the article below
Some four years after the 2008 financial crisis, public trust in banks is as low as ever. Sophisticated investors describe big banks as “black boxes” that may still be concealing enormous risks—the sort that could again take down the economy. A close investigation of a supposedly conservative bank’s financial records uncovers the reason for these fears—and points the way toward urgent reforms.
The financial crisis had many causes—too much borrowing, foolish investments, misguided regulation—but at its core, the panic resulted from a lack of transparency. The reason no one wanted to lend to or trade with the banks during the fall of 2008, when Lehman Brothers collapsed, was that no one could understand the banks’ risks. It was impossible to tell, from looking at a particular bank’s disclosures, whether it might suddenly implode. Red the whole article:
The authors of the above article don’t grasp the true cause of the banking panic. Yes, transparency is a problem, but that would ALWAYS be true under our current fractional reserve banking system–it’s inherently a Ponzi scheme that functions on public gullibility and government edict–banks get to violate private property rights.
PS: can anyone fill in the blanks? All panics arise from excess _______ over and above ___________. Correct answer wins this prize:
This was published on January 2, 2013, in Ron Paul’s Monetary Policy Anthology: Materials From the Chairmanship of the Subcommittee on Domestic Monetary Policy and Technology, US House of Representatives, 112th Congress. All the books mentioned in this article are free on the web, go to www.mises.org and do a book search by title.
The scholarly contributions of Murray N. Rothbard span numerous disciplines, and may be found in dozens of books and thousands of articles. But even if we confine ourselves to the topic of money, the subject of this volume, we still find his contributions copious and significant.
As an American monetary historian Rothbard traced the party politics, the pressure groups, and the academic apologists behind the various national banking schemes throughout American history. As a popularizer of monetary theory and history he showed the public what government was really up to as it took greater and greater control over money. As a business cycle expert he wrote scholarly books on the Panic of 1819 and the Great Depression, finding the roots of both in artificial credit expansion. And while the locus classicus of monetary theory in the tradition of the Austrian School is Ludwig von Mises’ 1912 work The Theory of Money and Credit, the most thorough shorter overview of Austrian monetary theory is surely chapter 10 of Rothbard’s treatise Man, Economy and State.
Rothbard placed great emphasis on the central monetary insight of classical economics, namely that the quantity of money is unimportant to economic progress. There is no need for the money supply to be artificially expanded in order to keep pace with population, economic growth, or any other factor. As long as prices are free to fluctuate, changes in the purchasing power of money can accommodate increases in production, increases in money demand, changes in population, or whatever. If production increases, for example, prices simply fall, and the same amount of money can now facilitate an increased number of transactions commensurate with the greater abundance of goods. Any attempt by “monetary policy” to keep prices from falling, to accommodate an increase in the demand for money, or to establish “price stability,” will yield only instability, entrepreneurial confusion, and the boom-bust cycle. There is no way for central bank policy or any form of artificial credit expansion to improve upon the micro-level adjustments that take place at every moment in the market.
With the exception of the Austrian School of economics, to which Rothbard made so many important contributions throughout his career, professional economists have treated money as a good that must be produced by a monopoly – either the government itself or its authorized central bank. Rothbard, on the other hand, teaches that money is a commodity (albeit one with unique attributes) that can be produced without government involvement. Rothbard’s history of money, in fact, is a history of small steps, the importance of which are often appreciated only in hindsight, by which government insinuated its way into the business of money production.
It was Carl Menger who demonstrated how money could emerge on the free market, and Ludwig von Mises who demonstrated that it had to emerge that way. In this as in so many other areas, Mises broke with the reigning orthodoxy, which in this case held that money was a creation of the state and held its value because of the state’s seal of approval. A corollary of the Austrian view was that fiat paper money could not simply be created ex nihilo by the state and imposed on the public. The fiat paper we use today would have to come about in some other way.
It was one of Rothbard’s great contributions to show, in his classic What Has Government Done to Our Money? and elsewhere, the precise steps by which the fiat money in use throughout the world came into existence. First, a commodity money (for convenience, let’s suppose gold) comes into existence on the market, without central direction, simply because people recognize that the use of a highly valued good as a medium of exchange, as opposed to persisting in barter, will make it easier for them to facilitate their transactions. Second, money substitutes began to be issued, and circulate instead of the gold itself. This satisfies the desires of many people for convenience. They would rather carry paper, redeemable into gold, than the gold itself. Finally, government calls in the gold that backs the paper, keeps the gold, and leaves the people with paper money redeemable into nothing. These steps, in turn, were preceded by the seemingly minor – but in retrospect portentous indeed – government interventions of monopolizing the mint, establishing national names for the money in a particular country (dollars, francs, etc.), and imposing legal tender laws.
Rothbard also brought the Austrian theory of the business cycle to a popular audience. Joseph Salerno, who has been called the best monetary economist working in the Austrian tradition today, was first drawn to the Austrian School by Rothbard’s essay “Economic Depressions: Their Cause and Cure.” There Rothbard laid out the problems that business cycle theory needed to solve. In particular, any theory of the cycle needed to account, first, for why entrepreneurs should make similar errors in a cluster, when these entrepreneurs have been chosen by the market for their skill at forecasting consumer demand. If these are the entrepreneurs who have done the best job of anticipating consumer demand in the past, why should they suddenly do such a poor job, and all at once? And why should these errors be especially clustered in the capital-goods sectors of the economy?
According to Rothbard, competing theories could not answer either of these questions satisfactorily. Certainly any theory that tried to blame the bust on a sudden fall in consumer spending could not explain why consumer-goods industries, as an empirical fact, tended to perform relatively better than capital-goods industries.
Only the Austrian theory of the business cycle adequately accounted for the phenomena we observe during the boom and bust. The cause of the entrepreneurial confusion, according to the Austrians, is the white noise the Federal Reserve introduces into the system by its manipulation of interest rates, which it accomplishes by injecting newly created money into the banking system. The artificially low rates mislead entrepreneurs into a different pattern of production than would have occurred otherwise. This structure of production is not what the free market and its price system would have led entrepreneurs to erect, and it would be sustainable only if the public were willing to defer consumption and provide investment capital to a greater degree than they actually are. With the passage of time this mismatch between consumer wants and the existing structure of production becomes evident, massive losses are suffered, and the process of reallocating resources into a sustainable pattern in the service of consumer demand commences. This latter process is the bust, which is actually the beginning of the economy’s restoration to health.
The concentration of losses in the capital-goods sector can be explained by the same factor: the artificially low-interest rates brought about by the Fed’s intervention into the economy. What Austrians call the higher-order stages of production, the stages farthest removed from finished consumer goods, are more interest-rate sensitive, and will therefore be given disproportionate stimulus by the Fed’s policy of lowering interest rates.
Equipped with this theory, Rothbard wrote America’s Great Depression(1963). There Rothbard did two things. First, he showed that the Great Depression had not been the fault of “unregulated capitalism.” After explaining the Austrian theory of the business cycle and showing why it was superior to rival accounts, Rothbard went on to apply it to the most devastating event in U.S. economic history. In the first part of his exposition, Rothbard focused on showing the extent of the inflation during the 1920s, pointing out that the relatively flat consumer price level was misleading: given the explosion in productivity during the roaring ’20s, prices should have been falling. He also pointed out how bloated the capital-goods sector became vis-a-vis consumer goods production. In other words, the ingredients and characteristics of the Austrian business cycle theory were very much present in the years leading up to the Depression.
Second, Rothbard showed that the persistence of the Depression was attributable to government policy. Herbert Hoover, far from a supporter of laissez-faire, had sought to prop up wages during a business depression, spent huge sums on public works, bailed out banks and railroads, increased the government’s role in agriculture, impaired the international division of labor via the Smoot-Hawley Tariff, attacked short sellers, and raised taxes, to mention just a portion of the Hoover program.
Rothbard had been interested in business cycles since his days as a graduate student. He had intended to work on a history of American business cycles for his Ph.D. dissertation under Joseph Dorfman at Columbia University, but he found out that the first major cycle in American history, the Panic of 1819, provided ample material for study in itself. That dissertation eventually appeared as a book, via Columbia University Press, called The Panic of 1819: Reactions and Policies (1962). In that book, which the scholarly journals have declared to be the definitive study, Rothbard found that a great many contemporaries identified the Bank of the United States – which was supposed to be a source of stability – as the primary culprit in that period of boom and bust. American statesmen who had once favored such banks, and who thought paper money inflation could be a source of economic progress, converted to hard money on the spot, and proposals for 100-percent specie banking proliferated.
In A History of Money and Banking: The Colonial Era to World War II, a collection of Rothbard’s historical writings published after the author’s death, Rothbard traced the history of money in the United States and came up with some unconventional findings. The most stable period of the nineteenth century from a monetary standpoint turns out to be the period of the Independent Treasury, the time when the banking system was burdened with the least government involvement. What’s more, the various economic cycles of the nineteenth century were consistently tied to artificial credit expansion, either participated in or connived at by government and its privileged banks. Rothbard further showed that the traditional tale of the 1870s, when the United States was supposed to have been in the middle of the “Long Depression,” was all wrong. This was actually a period of great prosperity, Rothbard said. Years later, economic historians have since concluded that Rothbard’s position had been the correct one.
Rothbard’s treatment of the Federal Reserve System itself, which he dealt with in numerous other works, involved the same kind of analysis that historians like Gabriel Kolko and Robert Wiebe applied to other fruits of the Progressive Era. The conventional wisdom, as conveyed in the textbooks, is that the Progressives were enlightened intellectuals who sought to employ the federal regulatory apparatus in the service of the public good. The wicked, grasping private sector was to be brought to heel at last by these advocates of social justice.
New Left revisionists demonstrated that this version of the Progressive Era was nothing but a caricature. The dominant theme in Progressive thought was expert control over various aspects of society and the economy. The Progressives were not populists. They placed their confidence in a technocratic elite administering federal agencies removed from regular public oversight. What’s more, the resulting regulatory apparatus tended to favor the dominant firms in the market, which is why the forces of big business were in sympathy with, rather than irreconcilably opposed to, the Progressive program. “With such powerful interests as the Morgans, the Rockefellers, and Kuhn, Loeb in basic agreement on a new central bank,” Rothbard wrote, “who could prevail against it?”
It is with these insights in mind that Rothbard scrutinized the Federal Reserve. He would have none of the idea that the Fed was the creation of far-seeing public officials who sought to subject the banking system to wise regulation for the sake of the people’s well-being. The Fed was created not to punish the banking system, but to make its fractional-reserve lending operate more smoothly. In The Case Against the Fed, What Has Government Done to Our Money?, and The Mystery of Banking, Rothbard took the reader through the step-by-step process by which the banks engaged in credit expansion, earning a return by lending money created out of thin air. Without a central bank to coordinate this process, Rothbard showed, the banks’ position was precarious. If one bank inflated more than others, those others would seek to redeem those notes for specie and the issuing bank would be unable to honor all the redemption claims coming in.
The primary purpose of the central bank, therefore, in addition to propping up the banks through its various liquidity injections and its position as the lender of last resort, is to coordinate the inflationary process. When faced with the creation of new money by the Fed, the banks will inflate on top of this new money at the same rate (as determined by the Fed’s reserve requirement for banks). Therefore, the various redemptions will tend, on net, to cancel each other out. This is what Rothbard meant when he said the central bank made it possible to “inflate the currency in a smooth, controlled, and uniform manner throughout the nation.”
Although Rothbard distinguished himself as a monetary theorist and as a monetary historian, he did not confine himself to theory or history. He devoted plenty of attention to the here and now – to critiques of Federal Reserve policy, for example, or to criticisms of government responses to the various fiascoes, the Savings and Loan bailout among them, to which our financial system is especially prone. He likewise looked beyond the present system to a regime of sound money, and in The Case for a 100 Percent Gold Dollar and The Mystery of Banking laid out a practical, step-by-step plan to get there from here.
In his work on monetary theory and history, as in his work in so many other areas, Rothbard showed from both an economic and a moral point of view why a system of liberty was preferable to a system of government control. At a time when the political class and the banking establishment are being subjected to more scrutiny than ever, the message of Rothbard takes on a special urgency.
For that reason we should all be grateful that his monetary work, and that of the other great Austrian economists, is being carried on by Murray Rothbard’s friend and colleague Ron Paul. By my reckoning, no one in history has brought true monetary theory and history to a larger audience.
Be aware of the fragility of companies no matter how powerful today.
Fortune 500 Firms in 1955 vs. 2011; 87% Are Gone.
What do the companies in these three groups have in common?
Group A. American Motors, Studebaker, Detroit Steel, Maytag and National Sugar Refining.
Group B. Boeing, Campbell Soup, Deere, IBM and Whirlpool.
Group C. Cisco, eBay, McDonald’s, Microsoft and Yahoo.
All the companies in Group A were in the Fortune 500 in 1955, but not in 2011.
All the companies in Group B were in the Fortune 500 in both 1955 and 2011.
All the companies in Group C were in the Fortune 500 in 2011, but not 1955.
Comparing the Fortune 500 companies in 1955 and 2011, there are only 67 companies that appear in both lists. In other words, only 13.4% of the Fortune 500 companies in 1955 were still on the list 56 years later in 2011, and almost 87% of the companies have either gone bankrupt, merged, gone private, or still exist but have fallen from the top Fortune 500 companies (ranked by gross revenue). Most of the companies on the list in 1955 are unrecognizable, forgotten companies today. That’s a lot of churning and creative destruction, and it’s probably safe to say that many of today’s Fortune 500 companies will be replaced by new companies in new industries over the next 56 years.
What Causes Corporate Decline According to Steve Jobs
Update: Here’s a related article from Steve Denning in Forbes, featuring some insights from Steve Jobs about what causes great companies to decline (power gradually shifts from engineers and designers to the sales staff) and how the life expectancy of firms in the Fortune 500 and S&P500 has been declining over time.
Peggy Noonan On Steve Jobs And Why Big Companies Die
There is an arresting moment in Walter Isaacson’s biography of Steve Jobs in which Jobs speaks at length about his philosophy of business. He’s at the end of his life and is summing things up. His mission, he says, was plain: to “build an enduring company where people were motivated to make great products.” Then he turned to the rise and fall of various businesses. He has a theory about “why decline happens” at great companies: “The company does a great job, innovates and becomes a monopoly or close to it in some field, and then the quality of the product becomes less important. The company starts valuing the great salesman, because they’re the ones who can move the needle on revenues.” So salesmen are put in charge, and product engineers and designers feel demoted: Their efforts are no longer at the white-hot center of the company’s daily life. They “turn off.” IBM [IBM] and Xerox [XRX], Jobs said, faltered in precisely this way. The salesmen who led the companies were smart and eloquent, but “they didn’t know anything about the product.” In the end this can doom a great company, because what consumers want is good products.
Don’t forget the money men
This isn’t quite the whole story. It’s not just the salesmen. It’s also the accountants and the money men who search the firm high and low to find new and ingenious ways to cut costs or even eliminate paying taxes. The activities of these people further dispirit the creators, the product engineers and designers, and also crimp the firm’s ability to add value to its customers. But because the accountants appear to be adding to the firm’s short-term profitability, as a class they are also celebrated and well-rewarded, even as their activities systematically kill the firm’s future.
In this mode, the firm is basically playing defense. Because it’s easier to milk the cash cow than to add new value, the firm not only stops playing offense: it even forgets how to play offense. The firm starts to die.
If the firm is in a quasi-monopoly position, this mode of running the company can sometimes keep on making money for extended periods of time. But basically, the firm is dying, as it continues to dispirit those doing the work and to frustrate its customers.
What’s interesting is that Steve Jobs lived long enough to show us at Apple [AAPL], in the period 1997-2011: what would happen if the firm opted to keep playing offense and focus totally on adding value for customers? The result? The firm makes tons and tons of money. In fact, much more money than the companies that are milking their cash cows and focused on making money. Other companies like Amazon [AMZN], Salesforce [CRM] and Intuit [INTU] have demonstrated the same phenomenon and shown us that it’s something that any firm can learn. It’s not rocket science. It’s called radical management.
Fifty years ago, “milking the cash cow” could go on for many decades. What’s different today is that globalization and the shift in power in the marketplace from buyer to seller is dramatically shortening the life expectancy of firms that are merely milking their cash cows. Half a century ago, the life expectancy of a firm in the Fortune 500 was around 75 years. Now it’s less than 15 years and declining even further.
The above articles are yellow flashing lights on the longevity of competitive advantage for established companies. Do you agree with the article’s premise?
Remember the cardinal rule of market analysis and investing: Those that know don’t say and those that don’t know have the floor to themselves.
You won’t find any great market or investment tips here. What we can do is learn investment principles, strategic logic, and tools and techniques to become better investors. 99.999% percent of your success will be in applying your own thinking to the opportunities in front of you.
Studying strategic logic will be an important part of building a mental model for investment success.
I chose Kodak’s demise and Bill Miller’s loss to highlight several points. Don’t follow market mavens off a cliff, make your own mistakes. You can’t lose when investing—either you make money or you learn. But to learn you must think systematically about your process, record your investments and think about your successes and mistakes. Secondly, unless you have mental models (thanks Mr. Munger) to understand reality, you will become lost. Mr. Miller and his team of 10 analysts including Michael Mauboussin might have been caught up in a turnaround story, the personality of a new CEO, the iconic brand name of Kodak or a plunging stock price—I don’t know—but they never asked a simple question—what competitive advantage would Kodak have in its new endeavor?
Let’s take a break to assess what is “Strategic Logic” or analysis of competitive advantages.
Strategic analysis should begin with two key questions: in the market in which the firm currently competes or plans to enter, do any competitive advantages actually exist? And if they do, what kind of advantages are they?
There are only three kinds of genuine competitive advantage:
Supply. These are strictly cost advantages that allow a company to produce and deliver its products or services more cheaply than its competitors. Sometimes the lower costs stem from privileged access to crucial inputs, like aluminum or early recoverable oil deposits (Saudi Arabia). More frequently, cost advantages are due to proprietary technology that is protected by patents (Pharmaceuticals) or by experience—know how—or some combination of both.
Demand. Some companies have access to market demand that their competitors cannot march (Ebay’s network effects). This access is not simply a matter of product differentiation or branding, since competitors may be equally able to differentiate or brand their products. These demand advantages arise because of customer captivity that is based on habit on the costs of switching, or on the difficulties and expenses of searching for a substitute provider.
Economies of scale. If costs per unit decline as volume increases, because fixed costs make up a large share of total costs, then even with the same basic technology, an incumbent firm operating at large-scale will enjoy lower costs than its competitors.
Beyond these three basic sources of competitive advantage, government protection or, in financial markets, superior access to information may also be competitive advantages, but these tend to apply to relatively few and specific situations. The economic forces behind all three primary sources of competitive advantage are most likely to be present in markets that are local either geographically or in product space. Pepsi loyalists have no particular attachment to Frito-Lay salty snacks, any more than Coke drinkers prefer movies from Columbia Studios when that was owned by Coca-Cola. Nebraska Furniture Mart, the store Warren Buffett bought for Berkshire Hathaway one afternoon, is a dominant player in Omaha and its hinterland, more powerful there than Ethan Allen or other large national furniture retailers.
Most companies that manage to grow and still achieve a high level of profitability do it in one of three ways. They replicate their local advantages in multiple markets, like Coca-Cola. They continue to focus within their product space as that space itself becomes larger, like Intel. Or, like Wal-Mart and Microsoft, they gradually expand their activities outward from the edges of their dominant market positions. (Source: Competition Demystified by Bruce Greenwald)
Think simply about competitive advantages. Morningstar categorizes economic moats in five ways.
Efficient Scale: when a company is effectively serving a limited market, rivals may have no incentive to enter. Some businesses are simply natural monopolies. This classification also applies to rational oligopolies. Think International Speedway for NASCAR races (geographic) or WD-40 in product space.
Network Effect: The value of a network is correlated to the number of connections. Large networks are most attractive for users, and it may be nearly impossible for upstarts to attain critical mass (Chicago Mercantile Exchange or CME).
Cost Advantage: Companies that thrive on being the low-cost provider in a commodity industry can offer lower prices to customers and still make a profit (Compass Minerals or Vulcan Materials). These companies create difficulty for higher-cost competitors.
Intangible Assets: Some companies have an advantage over competitors because of unique nonphysical assets such as intellectual property rights (patents, trademarks, and copyrights), government approvals, or brand names.
Switching Costs: If a company sells products that customers can’t get elsewhere—at least not easily—it has high customer switching costs. This creates a situation in which customers are willing to pay higher prices for products because of convenience.