- Superior Value Propositions
- Structural Competitive Advantages
- Economies of Scale
- Customer Switching Costs
- Network Effects
- Advantaged Culture
- Innovation as a Moat
- Vertical Competitive Advantages
- Attractive & Sustainable Economics
- Attractive Growth Opportunities
- Strong & Aligned Management
- Business Resilience
- ESG Considerations
- Some Misnomers on Business Quality
- Low Capital-Intensity
- Quality Outputs vs Inputs
One of the issues with "quality" is that it is impossible to define in an all-encompassing framework. There will always be idiosyncrasies and nuances with every business and industry that cannot be captured by a framework. That said, there are certain high-level characteristics that quality businesses have in common.
Superior Value Propositions
Central to any business is the value it provides to its customers. If a company does not provide real value to its customers, then eventually they will find alternative solutions, even if the barriers-to-entry are strong. Maintaining a superior value proposition requires reinvestment and improvement in a way that customers actually want — i.e. innovate but don’t over-innovate. Sometimes companies over-innovate, unnecessarily increasing their cost base when some of their customers do not value it, creating a price-umbrella for competitors to enter the market. Gillette razors and the Windows phone come to mind here.
It requires understanding when certain attributes become 'good enough' in the customers’ eyes such that the axes of competition shift — e.g. when performance is satisfied, customers often look to other factors like aesthetics or price. It can be powerful when a company’s value proposition is also a key structural competitive advantage ("moat") and when it is reinforced with scale (e.g. Amazon’s cost advantage is reinvested into the value proposition in the form of lower prices; Facebook’s network is both the value proposition and the moat).
Structural Competitive Advantages
Competitive advantages (“moats”) have two dimensions — advantages versus competitors and advantages versus the value-chain (e.g. suppliers and customers). They come in a variety of forms but only a few are sustainable over the long-term. Some examples include economies of scale, switching costs, network effects, intangibles, data, innovation processes, and advantaged cultures. We do not rely on things like a product advantage or a first mover advantage. Without something more, such things are not structural and sustainable. The best competitive advantages continue to strengthen as the company scales. If the mathematical compounding of returns is the Level I of compounding, the ability to re-invest earnings at attractive rates of returns is Level II, and the deepening of the moats from this growth is Level III. A quality business has all three.
We spend a lot of time understanding the deeper layers of these advantages. For example, it is not enough to simply identify a 'network effect' — we want to know how the network works, which parts of the network can be replicated, whether it is an exclusive network, if the underlying value proposition of the network can be satisfied through alternative non-network business models etc. We want to understand how the competitive positioning is evolving over time. We never conclude “this is a great business” but rather “this is a great business in the current industry context”.
We are wary of businesses with a single advantage, especially if this is a scale advantage or customer switching costs. Scale advantages are vulnerable to competition from well-capitalised incumbents in adjacent industries. Switching costs might help retain customers but they don’t help capture new customers and drive growth. They also typically annoy customers.
We are also wary of management teams that abuse their competitive advantages to the point they fail to reinvest in the customer value proposition or they become too extractive toward their customers or suppliers. A healthy and sustainable value-chain must be properly incentivised. We only invest in businesses where customers “want to”, not “have to”, use the product or service. Providing value is what truly sustains a business; competitive advantages just make it a easier to do this versus the competition but they are nothing without a strong value proposition.
Economies of Scale
Companies with high fixed costs can amortise them over a larger and larger revenue base (demand-side scale), thereby improving operating margins over time. This affords the company a cost advantage versus competitors and allows the company to spend a greater quantity of dollars for the same percentage of margin in areas such as research and development (“R&D”), marketing, or plant and equipment (i.e. asset utilisation) etc. The favourable amortisation of fixed costs as revenue grows is called “operating leverage”. On the flip side, it can be damaging when revenue contracts. Operating leverage can be as risky as financial leverage in some cases.
While operating leverage is valuable, economies of scale extend beyond this first order effect. Scale may help a company become more efficient overall. For example, greater access to capital equipment, specialisation of teams, bargaining power over suppliers, spreading of risk, reduced borrowing rates, synergies, cross selling, bundling etc. These are supply-side economies of scale. Economies of scale may also reinforce the value proposition through greater innovation or if the company reinvests the advantage into lower prices, creating a virtuous circle.
Overall, moats stemming from economies of scale on their own are not the most sustainable moats. This is especially true for demand-side economies of scale. Well-capitalised entrants with cheap funding sources may buy scale to compete. For example, Disney’s acquisition of Fox/Hulu made it a significant scale competitor to Netflix. However, economies of scale combined with other moats can be very powerful. Further, some businesses may have diseconomies of scale. For example, the business may become too complex to manage, returns can be diluted, the business may become less nimble, or the core business may prevent its ability to shift and compete when the market changes.
Customer Switching Costs
In some businesses, it is costly for customers to switch suppliers. Broadly speaking there are three types of switching costs — financial (penalties for breaking a contract etc), procedural (related to business disruption), and relational (interpersonal relationships or personal relationships with a brand etc). For example, software or systems that are linked to many aspects of a business’s internal processes, such as customer relationship management or enterprise resource planning software, may require significant effort to replace. This can increase the customer acquisition cost for competitors, particularly in saturated markets where most new customers are already being served.
Customer switching costs are not additive to the customer value proposition. Relying on these alone without offering real value to customers risks leaving the customers frustrated and eventually they will find alternatives. For example, this may be the case for fund administrators whose systems are often outdated due to lack of investment causing great frustration to clients. Further, customer switching costs do not provide an advantage when competing for new customers so they are less useful in a company's early growth phase.
Some business models utilise a network of customers and/or suppliers. A network effect exists when the value of that network to any individual member of the network increases as the network expands. For example, the value of Facebook to an individual is low when there are only 100 users but high when there are over 1 billion users. There are many types of networks — some examples include homogenous (one-sided) vs heterogenous (2-sided or more), unidirectional versus multi- directional (direction of value transfer), open versus closed, or protocol networks (where a set of standards helps coordinate users, such as market benchmarks like the S&P 500 or regulatory standards). Strong network effects make it hard for new networks to compete as incremental members would prefer to join the higher-value existing network.
Very strong network effects can lead to a winner-takes-all market structure where it is extremely difficult for new entrants with similar business models to compete. However, a key risk is that competition comes from alternate business models. For example, eBay had strong network effects as a marketplace and operated in a very strong position in online auctions in the US. However, Amazon’s business model was so successful in driving efficiency for new products that it impacted both eBay’s new and used products business. Another example is Uber. It operates in local monopolies or duopolies due to the strong network effects that drive better asset and driver utilisation. This makes it very hard for new ride hailing and sharing platforms to enter their markets. However, they are heavily impacted by other business models such as food delivery given that they compete heavily for the same labour pool.
Intangibles cover a wide array of things that are difficult to replicate even with unlimited capital expenditure. Some examples include strong brands, patents, trust, regulatory licenses etc. For example, Airbus and Boeing operate in a global aircraft manufacturing duopoly. Airlines require aircraft that they can trust not to fail, and it is extremely difficult for upstart aircraft manufacturers to compete against the inherent trust that Airbus and Boeing have built over decades.
"Organizational culture is the pattern of basic assumptions that a given group has invented, discovered, or developed in learning to cope with its problems of external adaptation and internal integration, and that have worked well enough to be considered valid, and, therefore, to be taught to new members as the correct way to perceive, think, and feel in relation to those problems." — Edgar Stein 1984, 'Coming to a New Awareness of Organizational Culture', MIT Sloan Management Review
Some company cultures are superior to others. Depending on the industry, a business can sustain a competitive advantage through its culture whether it is one of “cost discipline” or “innovation” etc. It is nearly impossible for large incumbents to change their culture since it is dependent on so many factors. Management cannot simply will it to change. While new entrants have the benefit of a fresh start, advantaged cultures are still difficult to replicate.
Some customer value propositions are dependent on data, sometimes directly, sometimes indirectly. If the data is critical and difficult to replicate, it may also serve as a durable competitive advantage. For example, Alphabet depends on data collected from how billions of users interact with their links to help improve their ranking algorithm in internet search. To a much lesser extent, Google search also relies on personal data to help make recommendations more relevant.
On balance, we are weary of data advantages. This is one of the most overhyped competitive advantage at present, especially given the emergence of AI, with every technology company claiming some form of data edge. Many take it at face value rather than digging deeper to truly understand if the advantage is structural. True structural data moats are rare. For example, the data collected in security software provides a certain level of edge. However, it is unlikely to be structural as the lifespan of the data is often short as threats change and adapt. Further, there are diminishing returns to more security data. Once competitors reach a certain point they compete on an equal data-playing field.
Interestingly, some data driven processes may also exhibit diseconomies of scale. The costs associated with scaling data storage, computational, and analytical resources increases with volume but the marginal benefit of new data, particularly long-tail data, may decline. As such, the margin cost may end up outweighing the marginal benefit.
Innovation as a Moat
Competitive advantages, even structural ones, are not static or permanent. While they afford a company time and flexibility, they will ultimately erode if the company does not use its privileged position to reinvest into the customer value proposition and into strengthening its competitive position. A key element is how the company reinvests into and fosters innovation. For example, a strong brand that signals product quality will not last if the product does not deliver on the customer promise. To the extent that the innovation process itself is difficult to replicate, then it may also represent a structural competitive advantage. For example, this may be the case if innovation requires significant spending that only large companies can profitably sustain (represents economies of scale), if a difficult to replicate culture or process is a key ingredient, or if the innovation is properly protected through patents. At the same time, companies can be at risk of over-innovating where customers do not value the increase in the value proposition more than the additional costs incurred. This can lead to pricing umbrellas or conditions ripe for disruptive innovation. Rob Vinall has some great observations on this topic in his 2016 letter.
Vertical Competitive Advantages
Strong and sustainable moats often go hand-in-hand with power in the value-chain but not always. Sometimes the supplier or customer is an even stronger company that, while not a direct competitor, can continue to extract value. For example, Booking Holdings and Expedia are a near global duopoly in online travel agencies (“OTAs”) but Alphabet sits at the top of their customer funnel with the potential to extract value in the form of higher keyword search and display advertising costs. Quality businesses have strong negotiating power over suppliers and customers. It is important to understand how the power is shifting in the value chain over time as things are never static.
While power in the value-chain is important, it can be abused. It is important that customers and suppliers are aligned and “want to” use the product or service, not “have to”. Squeezing customers or suppliers too much leaves them without profit and without incentive. For example, as the OTA industry consolidated, Booking Holdings and Expedia continued to exercise pricing power over independent hotels. While the independents “have” to work with these companies, they may not “want” to. This has been driving more and more independent hotels into the hands of the hotel flags such as Hilton, Marriott, and Intercontinental. These global brands and alternative business models may force pricing competition on the take-rate that OTAs can charge going forward.
Attractive & Sustainable Economics
A high-quality company must offer a superior value proposition and defend its competitive position, all while maintaining attractive and sustainable economics in the long-term. The reported financials can be misleading in this respect. Good companies may be underearning today due to a variety of factors such as capital investment, growth spending, or pricing. For example, Charter Communications is intentionally holding price lower than competitors and only increasing it gradually over time in order not to alienate customers. Further, the company Is undergoing a significant capital investment phase. As such, it’s current returns on capital are depressed. Similarly, bad companies may be overearning today due to unsustainable price increases, a lack of appropriate marketing spend, or under investment etc. Analysing the economics of a business from first principles, including the unit economics where appropriate, is critical to gain an appreciation of the long-term earnings power.
Attractive Growth Opportunities
In order to grow and deepen the competitive advantages, there needs to be opportunities to re-invest earnings into either the existing business or into complementary lines of business at attractive returns. Industries with secular growth tailwinds have a natural advantage here with a greater array of optionality. We also like our businesses to have meaningful adjacent opportunities where the business model will have a natural advantage — these are often hard to value and therefore less likely to be priced in.
Strong & Aligned Management
No matter how good the business, management controls the cash flows and capital allocation, and can easily offset the value generated. We assess management on 5 criteria.
- Integrity: Can we trust management to be good stewards of shareholder capital?
- Good executors: Management must be highly capable in their fields, be good managers of people, and be able to execute the right corporate strategy.
- Long-term focus: Management must be willing to forgo near-term profits to enhance long-term value. This can play out in many forms, for example, consumer goods companies must be willing to re-invest in their brands for the long-term, sometimes price should be kept artificially low in the shorter-term to ward off entrants, and sometimes entrants need to be bought or fought even if they do not represent a near-term threat.
- Disciplined capital allocation: Good managers are also good investors and are disciplined about the projects they invest in, the companies they acquire, and are willing to return capital to shareholders when there is no better use of capital. We need to understand the capital allocation process and how decisions are made.
- Strong alignment: Management and the board must be aligned with the creation of long-term value — both through economics and good corporate governance. The best incentive structure will depend on the company in question but it should focus on the key performance indicators that contribute to long-term value. Often the best form of alignment is outright stock ownership. At a minimum, the C-suite should stand to lose money if the business deteriorates.
Our key competitive advantage stems from our long-term capital base. This allows us to look past shorter-term changes in price and to instead focus on long-term value creation. Because we cannot time the market, our only defence against a recession, or any other unknown event, is to hold assets that can comfortably survive, if not thrive, in a recession. A key component of business quality is, therefore, how a company is likely to perform during tough times. We want to own companies that can maintain sufficient cash flow and balance sheet flexibility during these times to fund its operations, to continue to invest in essential growth areas, and to potentially take advantage of weaker competitors. Few companies have this luxury.
A key component of business resiliency is having a conservative balance sheet. Leverage cannot make a low-quality company into a high-quality company but it can do the reverse. A conservative balance sheet may reduce returns during times of growth but it provides invaluable flexibility during times of hardship.
Part of our mission is to maintain the highest ethical standards. We do not want to generate investment returns from businesses we deem unethical. Furthermore, businesses that are bad for the world are unlikely to be sustainable and therefore bring the business quality into question.
Some Misnomers on Business Quality
Low capital-intensity is often cited as a quality-business characteristic. While, all else equal, this is a desirable trait as it likely increases returns on capital while mitigating the risk of capital expenditure mismanagement, it is not always the case. For example, investment funds are low capital-intensity businesses but the low capital-intensity also means the propensity for competition is high. Further, some low capital-intensity businesses merely appear this way because of accounting standards. For example, consumer good companies expense most marketing costs rather than capitalising them on the balance sheet, which makes them appear lower in capital-intensity than in reality. A brand can depreciate and requires maintenance capital expenditure as much as any physical asset. What matters is not the capital-intensity but whether the asset being maintained, tangible or intangible, can be easily replicated or not.
Quality Outputs vs Inputs
Other metrics such as high returns on invested capital, strong margins, market share, and pricing power are also often cited as characteristics of quality companies. While high-quality companies have such desirable traits, these are outcomes of the high-quality characteristics mentioned above rather than defining characteristics. Simply looking for these traits may run the risks of missing high-quality companies that are investing heavily to grow, confusing an over-earning lower-quality business with a high-quality one, or missing the deterioration in the defining characteristics that led to these outcomes in the first place.