Competitive Moats - Part 2

This is the second article of our series covering competitive moats, a key pillar for how companies can sustain advantages over their competitors. Doing a competitive moat analysis is a key pillar of Redeye’s business rating, which we conduct to rate the quality of a business. This article has been adapted from Björn Fahléns book Quality First Investing: A checklist approach to finding and sitting tight in multibaggers, 2021.

The framework of Redeye’s moat checklist

At Redeye we assess the strength of a company’s moat based on six checks of quantitative and qualitative questions – five positive and one negative. These checks serve as a guide to finding the right answer to the main question for their respective sub-categories.

Each positive question is allocated one point if it can be answered with a ‘Yes’. The sixth question is a negative one – a red flag that can spell trouble for a company – where a positive answer removes one point from the score. The total number of these points makes up each sub-category’s score on a scale that ranges from 0 to 5 rounded to the nearest whole number. If the score is less than 0, it is nonetheless treated as 0.

If you are unsure about a question or disclosure is inadequate, the check fails by default. The goal is to be less wrong, rather than trying to be right. Also, this is consistent with the best ideas often being the simplest and to only invest in what you really know a lot about.

The moat strength checklist

1. Does the company enjoy market leadership?

2. Is the company’s competitive position strengthening?

3. Do returns on invested capital consistently exceed its cost of capital and outperform peers?

4. Does the business have a competitive moat that is easy to identify?

5. Does the company possess the ability to raise prices without losing customers?

6. Has the gross margin declined over the past three years?

1. Does the company enjoy market leadership?

Why does it matter?

This check indicates whether the company is the market leader in its core market as it highlights its ability to protect its turf – something that will have a direct impact on its ability to grow and flourish.

Market leadership brings many advantages such as greater brand awareness, more negotiating power with suppliers, more efficient production, more ability to attract talent, more experience, more data and more influence with regulators, allowing it to drive the market and create barriers to entry or scale for potential competitors. Also, competitors tend to focus on fighting weaker competitors while leaving the stronger ones alone.

If the market leader doesn’t make any serious mistakes, it can be very hard for followers to overtake the leader. Indeed, when you find a fast-growing quality company which is a market leader in a niche, you have found a potential multibagger.

How to assess it?

We consider a company a market leader if it is positioned to capture the greatest value in a market. It is not necessarily the largest player by market share, but rather the one that consistently outgrows its competitors and generates higher operating margins than them. There’s no better demonstration of strength than being able to knock out competitors so that you have more and more of the playing field to yourself.

A niche market strategy typically means focusing on overlooked customer segments that high-cost incumbents are unwilling, or unable, to focus on. Yet most great companies tend to start out focused on market leadership in a niche market and don’t have global leadership ambitions. However, the problem for a mature niche market leader is that re-investment opportunities are scarce. Under these conditions, the growth opportunity typically lies in increasing the market size rather than market share.

Further, with a growth strategy aimed at developing and dominating new niche markets, it is possible to cost-effectively sell to these markets with a relatively small sales force. Finally, there is often regulation slack for monopolism in niche markets.

If the company is in the top three in a global market, or number one if it is a local operation or a small market niche, the stock scores one point. If the company has no product sales yet, it scores no points.

2. Is the company’s competitive position strengthening?

Why does it matter?

This check indicates whether the company is likely to benefit from a growing market share for several years. If the customers are happy with the company’s offering, it will be reflected in the market share. The bottom line is that a true moat doesn’t just retain and maintain its existing customer base. It also attracts additional customers.

The greatest gains in a stock are usually made as a business is developing its competitive advantage rather than after it already has developed one. This is typically manifested in a growing market share. Whereas a declining market share indicates the opposite – problems with the product offering, customer dissatisfaction, and distribution challenges.

A business that is experiencing declining share is failing to attract new customers. Over time, it will lose its competitive advantage as existing customers either end up switching to other products or just quit buying them.

How to assess it?

We consider it as positive if the company is set to grow its market share over the next five years – or at least retain its market share if it is a market leader. What we are looking for here is a proven ability to win market share.

A good proxy for market share growth is increasing acceptance and usage of the company’s product. This manifests itself in an increasing number of customers.

On the negative side, market share weakens if the threat of competition increases. The latter could be due to a shift in consumer demand based on patent expiration, a new disruptive technology, or business model.

By comparing the ROIC growth rate in absolute terms and relative to the growth experienced by its nearest competitor, we can better understand whether the company’s competitive position is strengthening or weakening.

If the business is set to grow market share over the next five years, or at least retain its share if it is a market leader, the stock scores one point. If the company has no product sales yet, it scores no points.

3. Do returns on invested capital consistently exceed its cost of capital and outperform peers?

Why does it matter?

The good quantitative evidence of a moat is its ability to generate returns on capital that is greater than its cost of capital, and a history of doing so over time. This is the only way that growth adds any economic value. There is simply no value created when return on capital is below opportunity cost. In other words, a company whose return on capital is significantly above its opportunity cost over time, typically has a moat – whether they know it or not.

How to assess it?

Mathematical formulas won’t tell you how to get a moat, but they can help prove that you have one. Look for a return on invested capital (ROIC) that is higher than its weighted average cost of capital (WACC) over time. In this question we examine whether this ‘spread’ has endured over the past three years.

If return on invested capital (ROIC) is significantly higher than weighted average cost of capital (WACC) and higher than the average of its competitors over the past three years, the stock scores one point. If the company has no product sales yet, it scores no points.

4. Does the business have a competitive moat that is easy to identify?

Why does it matter?

If a company has some sort of moat that makes it resilient in the face of competition, the likelihood that it can sustain high returns over a long period is higher.

Many companies will have a few consecutive years where they hit the curve right and earn high returns on capital despite not having a durable moat. Accordingly, it is important that you can identify the moat before paying up for growth.

How to assess it?

What determines whether a company has a competitive moat is both quantitative and qualitative. This check serves to validate the qualitative side by trying to identify elements that make competition nearly impossible for competitors – factors that can hardly be copied, even with deep pockets. If you find these, the company probably has a strong competitive moat. The litmus test is if competitors’ attempts to enter the business have failed.

A good question to start with is: “What features are common to the longest lasting businesses within this sector?” This question will help you to understand what moat sources exist and are most relevant in a certain sector.

Finally, keep in mind that not all moats are global. They may only constitute a local structural competitive advantage.

If the business has a sustainable competitive advantage that is easy to identify and protects at least 50% of future earnings, the stock scores one point.

5. Does the company possess the ability to raise prices without losing customers?

Why does it matter?

The existence of a sustainable competitive advantage, or moat, will typically be demonstrated by a company’s pricing power, or consumer willingness to pay. This is the company’s ability to set its own prices, rather than have the market dictate the prices. The latter means that the price for the product is negotiated and the company must lower the price to keep the customer.

If the business can’t increase prices without losing customers (or it has long-term contracts where it can’t increase prices for a while), it’s likely to have to bear the brunt of higher costs in periods of inflation and watch its profits and margins decline.

The legendary Silicon Valley investor Marc Andreessen once said, “Raising prices is a great way to flesh out whether you actually have a moat. If you do have a moat, the customers will still buy… The definition of a moat is the ability to charge more.”

Pricing power is the opportunity to raise prices by more than the inflation rate without fear of losing customers or being undercut by competitors. This means that a business can raise prices in real terms without affecting unit volume, to generate superior returns on capital. Nonetheless, it is not an unlimited or unchecked ability to raise prices at any rate the business desires.

Strong brands are a well-known source of pricing power. Pharmaceuticals are another notable example of pricing power, at least until patents expire.

How to assess it?

When assessing pricing power, gross profit margin growth and consistently high gross profit margins relative to industry peers tend to indicate pricing power, while volatility in these metrics suggests otherwise. However, don’t rely too much on gross profits alone when comparing peers, as different companies account for expenses differently. Nonetheless, a strong value proposition and a dominant market share are also reflective of pricing power.

Michael Shearn, the author of The Investment Checklist, highlights several key characteristics in pricing power:

  1. Companies that have high customer retention rates;
  2. Customers who have low price sensitivity or only spend a small percentage of their budget on the business’s product;
  3. Customers that have plenty of cash or highly profitable business models;
  4. Customers where the quality of the product is more important than the price and a higher price is signalling higher quality.

Also, pay close attention when you see competitive industries undergoing rationalisations. As soon as they are consolidated down to three players (creating an oligopoly), the pain may already be gone and rational pricing will typically follow. Consolidated industries generally create a sort of pent-up pricing power that can be released in the form of real price increases. The message here is that you may find real pricing power in businesses that for some reason have not raised prices for a long period of time.

Finally, to sustain pricing power, the company needs to constantly improve the value it offers to the customer. If it doesn’t, its customers may become reluctant to accept the price or product innovation, allowing competitors to overtake or disrupt them. However, if the company remains at the forefront of innovation, it should be able to increase prices in line with the added customer benefits the innovation generates. Hence, when you look at pricing power you should always look at the company’s growth strategy, particularly if it keeps investing in its moat sources.

If the company has sustainable pricing power to increase prices above inflation without hurting unit volume, the stock scores one point. If the company has no product sales yet, it scores no points.

6. Has the gross profit margin declined over the past three years?

Why does it matter?

A declining gross margin is a warning sign. If competition gets tough or a company loses its competitive advantage, its gross margin usually declines. When revenues drop and the cost of making the goods stays the same, the gross margin will decline.

Conversely, gross margin growth over time is a good indicator of a company’s ability to reduce costs or maintain price increases without losing customers, i.e. achieving cost efficiency and/or pricing power.

How to assess it?

If the gross profit margin is lower than three years ago, one point is deducted from the sub-category’s score.