On catalysts and competitive advantage

Invincibility is good, if you can find it

Lewis, of Expecting Value, says says the ratio of price to book value ought to lead investors to ask particular questions about a company. There are many examples in his post, and I’d like to focus on two.

I call low price to book companies Thrifty because they’re cheap relative to the accountant’s valuation. Usually they’re cheap for good reason, they’re going through a business trough inflicted either by poor economic conditions, or management failures, or both, and the question an investor needs to answer about low price to book value companies is:

What’s the catalyst?

Which is jargon, for why business is likely to improve.

I’m not sophisticated about identifying catalysts. Running a large portfolio of shares you have to take pragmatic decisions and accept they won’t be right every time. As I wrote in September, beyond checking the company’s finances are strong enough to make insolvency a distant prospect, I look for positive signs like these:

New management, especially if they’re buying shares
Restructuring, asset sales, write offs
Talk of cost control and organic growth
An improvement in business performance.

Companies in the Nifty category tend to have higher book values. I call them Nifty because their superior records of profitability (i.e. return on equity) indicate there’s something special about them, which is why investors are prepared to pay more for the shares relative to that equity (i.e. book value). To invest in a Nifty company, you must be confident that whatever made the company special in the past will continue to make it special in the future.

This ‘specialness’ is competitive advantage, Warren Buffett calls it a moat, and so the question an investor needs to answer about high price to book value companies is:

Will the competitive advantage last?

Will the moat keep out the competition in perpetuity?

I’m even less sophisticated about identifying durable competitive advantages. In this video, which Calum, aka Valuhunteruk recommended in the comments on Lewis’ post, Buffett talks a lot about ‘mind share’, as opposed to market share. Millions, perhaps billions, of people think about Coca Cola when they’re thirsty, so it has mind share.

But then I read about iconic baby brand Mothercare in John McElligott’s and Lewis’ blogs and I begin to doubt mind share. When I think about push chairs or baby booties I think about Mothercare, yet in the UK Mothercare is being slaughtered by supermarkets and Internet retailers and there’s speculation it may close or drastically scale down its high street presence and focus almost entirely on its successful international expansion, where presumably it has little mind share.

Mind share alone is not enough, which is, presumably, why Buffett will only invest if he can imagine the company in ten years time (because it’s like it is today only bigger).

That makes me nervous about identifying durable competitive advantages because imagining the future is, by definition, speculative, although these may be hints of durability:

Consistently high ROE at a consistent level of leverage over a long period of time
A management team responsible for the company’s past success, that owns a significant stake in the business
Talk of cost control, organic growth, and extending a successful business model gradually into closely related markets
Prosaic businesses that are not threatened by rapidly changing technology.

Of the 23 companies in the Thrifty 30, eight trade above book value so technically they’re Nifty. The share prices of five are between one and two times book value and the share prices of three, Games Workshop, Printing.com and Ricardo are between two and three times book value.

The three niftiest all have plausible sounding competitive advantages. Games Workshop sells model armies for its war gaming systems, which seem entrenched among enthusiasts. Ricardo, which is an engineering consultancy, has accumulated decades of experience, research, and relationships.

Printing.com’s competitive advantage is its modern centralised hub, which allows it to compete with traditional high street printers on quality and price.

Like Mothercare though, Printing.com’s customers can source their printing online or reduce their printing by digitising their brochures and marketing. It may have a competitive advantage over its direct competitors in the high street, but I don’t know if that matters any more. Perhaps its more significant competitors aren’t on the high street.

Whether we’re talking about catalysts or competitive advantage, thrifty companies or nifty companies, the questions we ask about the companies we invest in can by summarised by one über-question, which is:

What inefficiency am I exploiting?

What wrinkle in the market, in the way investors behave, gives us the opportunity to profit?

Investors tend to underestimate the prospects of struggling but strong businesses, and invincible companies, and the reason there are fewer Nifty companies than Thrifty companies in the The Thrifty 30 portfolio is I find it easier to identify the struggling but strong than the invincible.

I think invincibility is harder to identify, because, generally speaking return on equity tends towards the mean, which means successful companies get worse and struggling companies get better:

If you’re predominantly a Nifty investor, you’re spotting exceptions. If you’re predominantly a Thrifty investor, you’re going with the rule.

For an alternative view, one that also inspired this post, see John ‘UK Value Investor’ Kingham’s comments, also on Lewis’ post.

16 Comments

John @ UKValueInvestor.com November 7, 2011 at 11:38 am

Excellent post Richard, not sure what I can add to it. I suppose you could phrase Graham as “will the bad times end?” and Buffett “Will the good times continue?”.

For me the answer is to try and buy robust businesses where possible so that they at least survive your holding period (I shall conveniently sweep my speculative punt in Luminar under the carpet). Then try to buy cheap, whether that be by assets, earnings, dividends or growth, or all of them if you can manage it.

That’s investing in a nutshell!

Reply
- Richard Beddard November 7, 2011 at 12:01 pm
  
  Thanks John, I feel we’ve been working this out over various blogs and comments distributed around the internet! It always comes down to good companies and cheap prices however you define the two.
  
  Reply
- blippy November 8, 2011 at 6:55 pm
  
  John, what an excellent way of putting it! That’s going in my quote file for sure!
  
  Reply
Trident November 8, 2011 at 7:41 pm

Good to see an article on competitive advantage, mind share and Games Workshop.

Mothercare just sells commodities at the end of the day, and into a very price sensitive market: very easy for supermarkets and internet sellers to encroach on their market.

But it’s different with GW – over a long period of time they have invested in building fantasy worlds – which I suspect is not really priced into their balance sheet. But more importantly they have a customer base who are keen on incremental buying and who have also invested considerable time in acquainting themselves with that world. They would give up a lot to move to a competitor who would also have to invest a lot into building their own fantasy world in which to place their products. Of course, competition can come indirectly, most obviously the alternatives provided in our computerised age which has probably placed a lid on GW’s growth prospects, but it it has weathered that attack.

It has no direct competition on the high street and seems almost unique in that regard.

GW has its moat and its defended by Orcs.

After years of investing on a part time basis and through the highs and recent lows I’ve come round to the conclusion that a portfolio that would give market beating returns and let you sleep at nights would comprise companies with clear competitive advantage (moats) – with the likes of GW, LSE, Dignity, Experian, Victrex, Genus etc. Some diversification would allow a few misreadings of the crystal ball when trying to understand what the future will throw up, and of course trying to buy at sensible prices.

Reply
- Richard Beddard November 9, 2011 at 10:43 am
  
  Hi Trident, well you’re in good company! I feel besieged by Buffetologists
  
  You may be right about orcs, super semen, and the certainty of death, the stories that lend credibility to the growth credentials of some of the companies you mention.
  
  But it’s easy to say Mothercare just sells commodities now they have been commoditised by Tesco and Amazon and the advantage goes to the company that can shift the most booties at the cheapest price. That’s the story now. I think the story twenty years ago might have been different. That buying a car seat, or a baby gym from Mothercare you were buying a high quality product that was safe. Mothercare were the experts, and nobody wants to compromise on safety or quality when it comes to l’il Jonny. No doubt they’d invested heavily in creating that reputation.
  
  Essentially, everything is a commodity once the competition gets to grips with it. Buffett likes Cola and Chocolate (in the form of Coke and See’s Candy). They’re commodities. The competitive advantage isn’t the product it’s something much more intangible, the emotional reaction customers have to the particular brand.
  
  Of course these stories give me confidence too, but I’m vary wary about raising them above the basic fundamentals of value and financial strength as a factor in investment. Let’s take Victrex as an example, as I have form. I fancied Victrex in January 2009: http://blog.iii.co.uk/victrexvct/ but I wasn’t running a virtual portfolio then. By the time I set up the Thrifty 30 in September it had risen in price (the market was recovering post-crunch) and so I rejected it from the initial line-up: http://blog.iii.co.uk/the-not-so-thrifty/ . Of course the price has continued going up.
  
  Right now Victrex is a titan of financial strength and it seems to manufacture a kind of kryptonite! It’s got an extraordinary record of profitability. But it trades at nearly six times book value. The argument for owning Victrex shares at the current price is, presumably, that Victrex’s technology, and patents, and position in the market is undervalued in its accounts by at least a factor of 6. That may well be true, but I’d need to know a lot a lot about intellectual property, material science, and the business of polymers to be confident in that judgement.
  
  I don’t think it’s sufficient to assume a durable competitive advantage because, so far, it’s proved durable. Neither is it sufficient to assume it because of the virtues of the product trumpeted in promotional material from the company.
  
  I’m not for one moment suggesting that’s what you are doing. But it’s what I’d be doing if I invested in Victrex now. I wish I’d invested in January 2009. Then I’d have been buying value and getting the story for free and I would truly have been able to sleep at night. Maybe that opportunity will come again, and I’ll be ready.
  
  Right now, though, I have no way of judging whether the shares are overpriced or not.
  
  Reply
  - blippy November 9, 2011 at 1:13 pm
    
    “I don’t think it’s sufficient to assume a durable competitive advantage because, so far, it’s proved durable.”
    
    You raise a good point. Buffett talks about businesses which will be the same in 20 years – but what business is really that unassailable? Look at his purchase of Washington Post in the 70′s. He probably should have ditched that years ago, but I think he has an emotional attachment to it. The newspaper is running at a loss, and it’s only the for-profit educational institution Kaplan that’s keeping the who thing afloat.
    
    Plenty of hedgies have been critical of these for-profit institutions. Eisman calls them “morally bankrupt” (http://bit.ly/tUsUq6), and poses the rhetorical question “Is for-profit education the next subprime mortgage crisis?”.
    
    Nothing is forever.
    
    Reply
- blippy November 9, 2011 at 12:48 pm
  
  “GW has its moat and its defended by Orcs.”
  
  Agreed. It has a niche that Steam and computer games in general wont really be able to dismantle. As long as the world doesn’t run out of 14-year old boys, I think they’re safe.
  
  I think the problem with “moats” is that it’s a bit of a two-edged sword. Whilst the business is protected from encroachment, it is usually difficult to expand, too. Buffett talked about See’s Candy, and how it found it impossible to extend its geographical boundaries. I also heard about WD40 – the lubricant – the world only needs so much lubricant at one time. It’s very difficult to manufacture growth in your niche, generally. You can earn fantastic returns on capital, but to what avail, as you can’t reinvest that capital meaningfully. I think GW tried it realier this decade and came a cropper. They then had to retreat and stick to what they did best. I haven’t been following their story, though, so I’m not sure what the deal was on that one.
  
  “DTY” – just had a quick squint at them. The problem here is that they have a gearing of 3545%, an interest cover of 2.96, and a z-score of 1.3. That’s looking awefully tight. So maybe it’s a nice idea that got carried too far too fast. I’m going into it blind, though, so forgive any ignorance on my part.
  
  “LSE” – something that certainly sounds like it has a bullet-proof moat, but I hear that it is up against competition. I’m not sure what that’s about, though. I see that it’s got monster margins, so it certainly looks like some goodness is going on there.
  
  Reply
Professor Professorson November 9, 2011 at 9:20 am

I am struck by how widely Warren Buffett’s investment strategy varies from Graham’s. I’m not even sure he’s a value investor!

John’s comment above sums it up well – Graham’s approach is ‘will the bad times end’ (turnaround opportunities) and Buffet’s is ‘will the good times continue’. That to me suggests Buffet’s approach is based more around growth than value. Or growth at a reasonable price as I saw it described elsewhere.

The most recent Berkshire Hathaway balance sheet shows $50 billion of goodwill compared to around $170b of shareholder equity, it pays no dividends and has just announced share buy-backs. What would Graham have made of that!?

Reply
- Richard Beddard November 9, 2011 at 11:01 am
  
  Hi Prof, you kind of answered your own question! Buffett factors growth into the value equation.
  
  Towards the end of his career Graham seemed to reject the intrinsic value approach (i.e. estimating the future earning power of a company and calculating its current value) because it was such a competitive business. I don’t think he thought it was impossible to profit this way though, just very hard work. Buffett claims to take just five minutes to make an investment decision so either he’s made it very easy or he’s brushing all the preparatory work under the carpet
  
  Reply
Jeff Matthews November 9, 2011 at 12:08 pm

Richard,

The way Buffett would respond to the Mothercare example (I believe) is by asking “How much money would it take for me to knock off this franchise?” That’s the question he asks himself when evaluating a business.

Branson tried to compete with Coke via Virgin Cola, which didn’t work, and probably helped prove there’s not enough money in the world to knock off Coke–and that’s why Buffett calls it one of his “permanent” investments.

However, Buffett has several businesses that have lost their moats–Fruit-of-the-Loom (underwear), Worldbook Encyclopedias, Nebraska Furniture Mart. In all cases, Berkshire didn’t reinvest enough in the business or was undermined by lower-cost technology, or both. Technology shifts are deadly–which is why Buffett distrusts technology investments, and why he likes Coke: it’s unlikely a new “technology” will replace drinking fluids, the way CD-ROMs replaced physical Worldbook Encyclopedias!

As for Buffett not being a true “value” investor, that has been the case since he met Charlie Munger and they bought See’s Candies in 1972. Buying See’s (for a higher price relative to tangible assets than Buffett wanted) and the ensuing multi-billion return on that $25 million investment showed Buffett the power of intangibles, and let him to buying Coke at a time when most Wall Street analysts thought it was overpriced.

Burlington (the railroad) is an excellent example of thinking about an investment in terms of “What new technology could knock off this business?” and “How much money would it take to compete?” In both cases, Burlington’s track system is no longer duplicable, and so long as a cheaper form of bulk transport doesn’t come along, Burlington is secure.

Cheers,
JM

http://www.amazon.com/Secrets-Plain-Sight-Investing-ebook/dp/B004X6ZEOO/ref=pd_sim_kinc_2?ie=UTF8&m=AG56TWVU5XWC2

Reply
- blippy November 13, 2011 at 1:54 pm
  
  “Buffett has several businesses that have lost their moats”
  
  Jeff, that’s a good point. Nothing is forever, and that ties in nicely with what Richard was saying about his lack of confidence in determing the true staying power of a company. He brings home the point that “nobody really knows”. Even Washington Post, as Buffett-esque an investment as they come, looks distinctly ragged around the edges these days.
  
  Reply
  - Richard Beddard November 14, 2011 at 9:31 am
    
    That’s my argument, although some people can know more than others, by virtue of his reputation and the size of his shareholding Buffett is an insider in many of the businesses he owns, which is why I’m so wary of trying to ape his strategy. Over decades he’s engineered an ecosystem around himself – that’s his competitive advantage. Very difficult for other investors to replicate. And even if we could we wouldn’t start out investing the way he does now at the beginning of his career.
    
    Reply
Richard Beddard November 9, 2011 at 1:25 pm

Hi Jeff,

Thanks for the link to the book. It looks good – low cost, even handed and updatable. Now those are novel concepts. Perhaps it gives you a competitive advantage in the Buffetology market I’ve bought it.

The question though, “How much money would it take for me to knock off this franchise?” is difficult to answer isn’t it? It depends on lots of judgements an investor probably doesn’t have the information to assess, which is why Buffett sticks to his ‘circle of competence’.

If BH wasn’t a massive conglomerate, but a small asset management company, investing in listed companies, what would Warren do? Would he still be looking for moats, or do you think he’d be more opportunistic?

I reckon you’re in a good position to answer that question!

Reply
Trident November 9, 2011 at 8:39 pm

Hi Richard,

I just mentioned a few names where companies have got competitive advantage (or a quasi monopoly position). I haven’t looked at Victrex for some time and from memory I think their patent may run out in the near future – but I do recall looking at them several years ago and like you not taking the plunge.

Dignity, I merely quoted as a dominant provider (scale economies) in a fragmented market. As a rule I don’t like debt and acquisitions – but with Dignity I think you have to look at their balance sheet in the context of a policy of large special dividend payments.

One of the comments that I though was interesting was that it was all well and good to have a big ROCE but in a niche market if you can’t grow you can’t re-invest it. Some truth in that, but in that case the right thing to do is to have the money back to the shareholders. Something that GW is now doing. It saw very strong but unsustainable sales growth a few years ago on the back of product tied in to the Lord of the Rings films. It was easy money and in truth the cost base got fat and took longer to trim than the falling sales.

It then embarked on a successful cost cutting program and is recently trying to develop it’s niche in the US which if successful would see mouthwatering growth – the jury is out on that at the moment though.

But I think it’s accounts are worth looking at from a Buffetologist perspective. Huge gross margin, very healthy net margin, ROCE to die for, etc.

Visible management attitude at GW? Get hold of a hard copy of their latest accounts: cheap paper, no photographs, no colour, no gloss and bound by gaffer tape. I kid you not. And I bet they send them out 2nd class. Nifty and Thrifty!

Reply
- Richard Beddard November 10, 2011 at 9:37 am
  
  Here’s a distinction I’d like to make. These are companies I’d like to work for. The businesses are stable, growing and likely, as far as we can tell, to remain so. I’d just make the point that investors tend to accept the stories around them uncritically. For example, when I looked at Dignity in 2008 ( http://blog.iii.co.uk/dty/ ), the story around it seemed to be that it could continue juicing up earnings by issuing debt securities and buying back shares. You’re probably going to tell me it still is! But you can imagine scenarios where that might not be true, very high interest rates maybe. My worry is investors latch on to the stories uncritically, and therefore loose track of value. It’s very hard to value intangible ‘stories’.
  
  I tend to think the opposite, companies that seem invincible eventually fail to live up to that expectation. Something will undermine them. As you say Games Workshop undermined its own business by expanding recklessly on the back off exceptional profits. It was a terrifically bad investment for investors that bought into the prior story of invincibility. By promising to be more disciplined the company is winning back its reputation, and obviously I’m happy about that! But I don’t take it for granted. And I wouldn’t add more of the shares to the portfolio unless I thought it was obviously cheap. That’s my ‘margin of safety’ in value investing jargon.
  
  So, I accept what you say about these companies, but sometimes it’s what we don’t know that matters.
  
  Reply
Friday Reading | Expecting Value - UK Value Investing Blog November 11, 2011 at 6:53 pm

[...] always more to learn, though, and so I was rather pleased to see Richard Beddard post a sort-of reply to my post on book value and returns last week. As well as rather neatly delving further into the [...]

Reply