Updated: Jun 27, 2019
If you're curious and want to read more, here are the business model posts so far
Up until now, these blog posts have been focused on investor psychology and the soft skills of investing. This week, I want to take a look at something a little more concrete: identifying good businesses.
As we know, good investing means owning good businesses. But finding these can be tricky since there are so many to choose from.
If you were to ask a seasoned investor this question: how can you tell a business is good? They might respond, "Evidence of high returns on capital for a long time."
But what does this mean? Let's break it down since that sentence puts me to sleep and it's likely the same case for you too.
T-Shirts Galore LLC
Let's say you start a clothing company, mainly selling T-shirts. To make money, you need to sell each T-shirt for more than your production costs. That would be your gross margin.
If it costs you $10 to make a shirt and you sell it for $20, your gross profit is $10, or gross margins of 50% (10/20).
However, you need to think about other expenses like shipping costs, website development, or even salaries. These are called operating expenses. Let's say you do the math and your operating expenses come out to $5 per shirt.
Now your operating profit per shirt is $5 (20-10-5), or 25% operating margins (5/20).
Then you have things like interest expenses if you take out a loan or taxes that give you a net profit number. We'll say these items cost you $2 per shirt.
So now, after all of this, you are making $3 per shirt (20-10-5-2), or 15% net profit margins (3/20).
But still, we need to go a step further. We need to calculate how much money you spent on assets. These are things like unsold shirts, a printing press, or even a storefront.
Let's say you forego the storefront and only have $1,000 in assets.
If you make 100 shirts with the same profit margins, your return on invested capital would be 30%. (100 shirts*$3 profit margin)/1000 (in assets). This is pretty good! If you think about it from an investor's perspective, 30% returns are awesome.
So this is the first part of that sentence, "evidence of high returns on capital." But now we have to deal with the second part "for a long time."
The thing about business is that there is competition. We live in a capitalistic society, where competition is healthy and good for consumers. The businesses that give consumers the most value usually do pretty well.
But let's go back to T-shirts. Maybe you tell your friend about your business and how much money you're making and he gets jealous so he backstabs you and starts his own.
He conjures up a plan. If he sells his shirts for less than yours, while keeping the same quality, customers will flock to him. So he copies you but sells shirts for $18 instead of $20. He is willing to take lower profit margins since he believes 10% returns aren't too bad (using the same numbers from above).
Just like the world's richest man, Jeff Bezos, said, "Your margin is my opportunity."
Understanding competition is extremely important because, if your business can be easily copied, your margins will be undercut, leaving you grasping for profitability.
Businesses that can continue to earn high returns on invested capital for a long time have something investors like to call "moats." Just like a castle has a moat with a drawbridge to keep enemies out, good business have moats to keep the competition at bay.
Moats are a fascinating topic because it gets to the core of good investing: what makes a good business? Or in fancy, investor-speak, what allows a business to earn high returns on invested capital for a long time?
There are many types of moats, some more defensible than others. One way to think about a moat is: how hard would it be to replicate or disrupt this business even if able competitors had a ton of money?
Think about Google. How on God's green [google]Earth would you build a better search engine? Think about how many years of data it has aggregated and how many world-class engineers it employs. Think about the massive amount of cash it could deploy if you started making superior technology. It would just buy you out for millions and you could sail off into the sunset.
Or think about Amazon. There's no way you could replicate the brand and gargantuan scale it has built up over 20 years.
These two businesses provide powerful examples of moats, but there are many more.
Think about Ferrari. People don't buy Ferrari's because they are practical. They buy them for social signaling. Usually, these high-end brands provide the highest quality production which allows them to maintain pricing power.
Another moat is superior people. If, somehow, your T-shirt company poached Nike's head designer away, that would probably help you. But this is a reason that the strong just keep getting stronger. Which company has the resources to hire better people? Facebook or your cousin's tech start-up?
Furthermore, two particularly strong moats are network effects and being a low cost provider. Amazon has both.
The definition of a network effect is that the ecosystem gets stronger as more people join. On Amazon's marketplace, the more sellers there are, the more value there is for buyers, so more buyers make Amazon accounts, which means there are more buyers for sellers, so more of them sign up and the loop continues indefinitely. This is a network effect.
But Amazon also benefits from being a low cost provider. It has the scale to spread out its fixed costs over a huge consumer base. Therefore, it is willing to take lower margins to be a fierce competitor.
Another example is a patent. If you are the only company that can sell a good, you can charge a pretty penny. Once a patent expires, you're usually toast though.
I could go on and on with examples but I think you get the point. Some companies are hard to compete with because of certain structural advantages.
Your T-shirt company was easily replicable. It would be another story if your design was world-class and you had a sought-after brand. Or if you had immense scale to distribute shirts for rock-bottom prices.
But that's why business is hard. Everyone wants to make money so you have to constantly be evolving and learning.
At the beginning, you might be making good returns on capital, but over time, competition can gnaw away at your margins. It's a healthy process that usually rewards the people who create the most value.
As an investor, identifying and recognizing the difference between companies with and without moats is essential to success. It takes a little bit of practice but one thing that really helps is just putting yourself in the shoes of the customer.
For example, it's helpful to ask questions like:
- why would I buy a $10 Netflix subscription when Hulu is offering this $8 special?
- why would I choose to buy this enterprise software over another one?
The companies that continue to win customers over with strong value propositions are able to do so because of fierce competitive advantages, also known as moats.
Look for these companies and hold them as long as you can. That's all there is to it :)
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