In the long distant past an eager young investor put every cent he owned into stock of the company that made the first mouse trap the world had ever seen. Sales skyrocketed and the young man bought more and more shares, certain the company could not fail. And then along came a competitor who built a better mousetrap.
If you follow US markets you may have heard of a company called Palm, the company that introduced the world’s first Personal Digital Assistant (PDA) called the Palm Pilot. The PDA morphed into the Smartphone but Palm was long gone by then. They had no competitive advantage to sustain them once the likes of Sony and HP and a myriad of others jumped into the lucrative PDA market.
Intelligent investors have long known that success breeds competition and without a sustainable advantage, the originator of a product or a service can quickly fade away.
Warren Buffet capsulized the essence of competitive advantage when he coined the term economic moat. Castle walls with open fields at their gates are more vulnerable than those surrounded by a moat; and the wider the moat the greater the advantage. In share market investing, companies with a moat have attributes that will make it difficult for competitors to enter the market in the first place, and/or difficult to catch up.
Morningstar Inc now has the proprietary rights to use the term so you will not see it pop up in research reports from other firms. Regardless of whether you call it competitive advantage or an economic moat it can be difficult to spot these attributes while the moat is under construction.
So what goes into an economic moat? There are several attributes and the more a company has the wider their moat. Here are some of the factors that lead to economic moats:
Cost of Production
Market Share as a Barrier to Entry
Patents, Copyrights, Licenses as Barriers to Entry
Cost of Switching to a Competitor
Cost of Production
Some consider this to be the most powerful of all competitive advantages. Companies enter markets to make more profit – determined not only by price and demand.
If it costs a company $9 to produce a product that sells for $9.25, the company cannot survive much margin pressure. A company with a lower cost of production, at $7.00, can undercut on price and drive competitors out of the market. In addition, low cost of production means more profit compared to a competitor with higher costs of production.
As companies grow, economies of scale contribute to low costs of production. A company the size of Woolworth’s can squeeze costs from their suppliers that smaller companies simply cannot match. This is a classic example of the rich getting richer. The bigger you are, the better the deals you can negotiate with your suppliers – driving your costs of production lower and lower.
When a potential competitor gazes on a moat-protected company’s profitability, one thing that can scare them away is market share. Barriers to entry are exactly what the phrase implies – anything that would make the competition think twice before committing resources to invading. If a company has 50% or more market share there is not much room for several new competitors to successfully penetrate the market.
Patents, Copyrights, Licenses
Governments issue licenses to operate certain businesses, and patents and copyrights safeguard a moat-protected company’s product offerings. As you know patents expire and licenses can be revoked.
When a competitive product enters a marketplace current customers may switch to a superior product, but what it costs them to switch can be a powerful driving force to keep them where they are. Computer software and hardware is a good example. If a company’s IT infrastructure comes from a moat-protected company, the cost of switching to a new IT provider can be prohibitive.
People tend to spread the word about products or services they use for two reasons relevant to economic moats. The first is satisfaction with the product and the second is recognition of the unique features of the product or service. As word of mouth spreads more customers try the product and their praiseworthy comments in turn continue to increase the size of the network.
Brand Identification is an intangible asset that serves as a powerful competitive advantage. New entries that face a brand with strong customer support have a high barrier to climb. Customers identify with a brand for a variety of reasons ranging from product quality, customer service, convenience, and pricing. Other intangibles some investors look for are executive leadership, a unique corporate culture, and internal skills. While brand identification can be measured to a degree through market research studies, leadership and culture are soft attributes that can be impossible to quantify.
Some growth investors focus on anything new and different as the competitive advantage to look for; as long as the capability to keep offering new and different products and services is there. In the short term this sometimes works but skilled employees can be lured away by competitors and most technological innovations can be copied in time.
Assessing a fuller range of completive advantages from an economic moat is a basic tenet of value investing.
While spotting an economic moat in the early stages is difficult, picking up temporarily sold-off stocks with moat-like characteristics is one way to get on board cheaply.
The following table includes six ASX 200 stocks that have competitive advantages in one or more attributes of an economic moat.
Mrkt Cap ($M)
52 Wk Hi
| 52 |
Earnings Growth 10 Yr
Earnings Growth 5 Yr
Earnings Growth 1 Yr
Ramsey Health Care
All stocks are large caps and their earnings growth figures reveal strong performance over the long term. Clearly, the ten year numbers reflect the mining boom of the first half of the last decade, as evidenced by resources and energy service provider Worleyparsons. However, five out of the six have weathered the GFC and its aftermath.
Let’s take a look at each of these companies to spot competitive advantages that may have contributed to their outperformance.
Woolworths Ltd (WOW) arguably has the widest economic moat of any stock on the ASX. They are the lowest cost producer in a highly competitive space. Their 5 year average profit margin of 4.0% bests rival Wesfarmers’ 3.5%. Despite increasing competition they still have dominant market share and their sheer size and operating efficiency gives them buying power few can match. They currently have the most recognised brand name in Australia.
Here is their ten year share price performance chart compared to the ASX 200 Index the XJO:
It is worth noting that WOW has done well in the face of a slowing Australian economy and weakening consumer sentiment. With a reasonable P/E of 16.22, a dividend yield of 4.3%, and a 2 Year Earnings growth forecast of 3.6%, Woolworths is one to place firmly on your watch list.
Woodside Petroleum (WPL) has first mover advantage in the LNG (Liquefied Natural Gas) space but market concerns about rising LNG capital expenditures have hurt them. Energy giants like Chevron and Conoco Philips have major projects underway but WPL already has more than 20 years of experience in managing the development of LNG projects. Their Pluto project is now producing and they already have 20 year contract agreements for LNG that has yet to be produced. Their customers include Asia’s top utility companies who obviously can’t switch to a competitive producer since they are contractually bound. Here is their ten year share price performance chart:
If you have been following the LNG story you know there are a growing number of prophets who claim the cost overruns will destroy the supposed golden age of gas before it ever begins. Chevron and Shell have expressed concern and delays and even cancellation of some projects are possible. Woodside is ready to start shipping.
Rising demand for natural gas as an energy source and the capability of LNG to meet that demand, places WPL firmly in the hot seat. Investors bullish on gas can’t overlook Woodside.
Coca-cola Amatil Ltd (CCL) is 30% owned by the US Coca-Cola Corporation and has the advantage of exclusive distribution rights of the world’s most recognised brand. The immense power of the Coca-cola brand name means CCL has strong pricing power. The demand for Coca-cola products has allowed CCL to build a massive distribution network throughout Australia into which the company can place new products like alcoholic beverages. The sheer size of that distribution network and the overwhelming brand identification makes threats to their existing dominant market share virtually non-existent. Here is their ten year share price performance chart:
With a 3.9% dividend yield and an 8.9% 2 year earnings growth forecast, CCL qualifies as a target for any investor seeking safety in a company whose share price has actually been going up in today’s precarious share market.
Worleyparsons (WOR) provides a wide variety of professional services to both the resources and energy sectors. The company has benefited enormously from the resources boom – rising an astounding 1200% over the last decade. Here is their share price performance chart for that period compared to the ASX 200 Materials sector XMJ:
WOR is one of the top five international engineering services providers with blue chip clients in both existing energy and resources sectors as well in the burgeoning unconventional energy sectors, like shale oil and shale and coal seam gas. The size of their operation alone gives them a competitive advantage. Add to that their reputation for having some of the best skilled personnel available, and you have the makings of a network effect. The success of their work with long term clients spreads across the industry. Their services are based on long term contracts and often involve an on-site presence of Worleyparsons personnel, making switching costs a barrier to competitors looking to capture market share from WOR.
While the ten year performance is exemplary, WOR has suffered a bit from flailing resources sentiment and the share price has dropped 5% year over year. With a P/EG of only 0.85, a respectable dividend yield of 3.5%, and a 2 year earnings growth forecast of 21.1%, WOR is only a stock for those confident of bouyant resources and energy market activity.
Ramsey Health Care (RHC) has been one of the top performers in the ASX this year and some analysts are cautioning the stock price has run too far too fast and it is time to sell. Here is their one year share price performance chart versus the ASX Healthcare Index (XHJ), immediately followed by a ten year chart:
Ramsey has several competitive advantages – most importantly its size, offering substantial economies of scale. It is the largest private hospital operator and is expanding its hospital and same day surgery presence in the UK, France, and Indonesia as well as Australia. It currently operates approximately 117 facilities, and growing.
Ramsey’s scale allows them to negotiate favorable terms with health care funds, passing along increased costs to the funds. Their size also gives them an advantage with suppliers. Many of their facilities in Australia have long standing reputations that qualify as brand identification. Finally, government regulations promoting private health insurance as a supplement bode well for their future.
If you look at Ramsey’s one chart you will note that SELL recommendations from the major brokers have done little to dent the share price; sell recommendations from Citi, in February, UBS in March and RBS Australia in early July have not halted the upward trending share price.
The final stock in the table is James Hardie (JHX), a manufacturer of cement based siding products for construction applications.
JHX does a lot of business in the US – and the building construction collapse hit them hard. Nevertheless, they have rebounded strongly in the past year. Note from the table above a 234% earnings growth over 1 year. The reason: the company swung from a $336 million dollar loss in FY 2011 to a net profit after tax of $580 million in FY 2012. Here is their one year share price performance chart:
James Hardie has several competitive advantages beginning with patents. Their research and development efforts over the years have paid off with patents granted for their fibre based products. Competitors have tried to copy their products, but none have yet to crack these trade secrets. JHX still holds over 85% of the US market. With a dividend yield of 3.3% and a P/E of 8.23, JHX is worth researching further.
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