VP Workbook 1- How to find MOAT? (SWITCHING COSTS- Meaningful Relationship Between Need and Investment)

Hunt the moat from financials

I always struggled to find a knowledge hub where some one can go and with a click of button get the relevant questions and answers on key aspects of investment practice such as Moat, Management, Valuation, Risk and so on.

I hope this will be helpful to DIY (do it yourself ) investors at least in drawing attention to right questions. For new DIY’s they including me can start with gun shot, for experience folks they can correct questions and answers.

I picked up VP term basis on ValuePickr with due permission of @adminph2 .

Please create different checklist as you feel on other subjects which are relevant to look while analysing a stock.

I am starting with a few questions…will keep adding as we progress.

HUNT THE MOAT FROM FINANCIALS

Profit & Loss Account

All numbers to be checked is for minimum ten financial years.

  1. Is the gross profit of company growing consistently?

Tips- increasing Gross Profit indicates superior pricing power. I use 40% as tentative number.

  1. Consistent spending of non-cost of goods sold expenses (selling, general and administrative expenses).

Tips- the trick here is consistently, high spending doesn’t matter… fluctuates are the one who may be facing turbulence.

  1. High spending on R&D may indicate absence of moat. So look out for the companies with little R&D (research and development). My cut off is 15% maximum of Gross Profit.

Tips- most of R&D is related to technological advancement. It points out that company will require always money in for of R&D to stay updated in technology.

  1. Lower depreciation cost to gross profit as a percentage. Compare with a similar competitor to find out a base.

Tips- higher depreciation cost indicates higher maintenance expenses for managing asset. At bad times this will eat our cash flows away.

  1. No interest or lower interest expenses. Compare interest to gross profit with a competitor.

Tips- high interest companies often taken loan to fund their capital expenditures, working capital to stay in competition.

Now a caution after warning: concluding anything on a single parameter is recipe for disaster. For high R&D is not always bad, say the pharma companies who spend big bucks to make equally big bucks. Pharma enjoys regulatory protection, which is “Global Restricted Patents” , a super sign of moat.

The first idea is to pluck low hanging fruits, imagine a company who is churning lots profit year after year without spending capex, interest and R&D.

Confession- these questions I have used from my Guru’s note book in turn I think his influence was Seth Karman’s practice notes.

An idea is powerful than a name or tip- Seth Klarman

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Second set of Questions

The below are very simple techniques, yet I find them powerful while practicing. Some of them tells you what you see may not be true always e.g.:
- high debt equity ratio with a good dividend track record, buy back may be a sign of moat.
- Or low current ratio with high earnings, buy back or dividend can be very good.

  • high stock pile of inventory may indicate superior product profile and order book.

Explore for yourself and let me know.

Question: Whether Net Earnings for company showing a consistent upward trend? (last ten years).
Hint- remove share buy backs, other income to normalize earnings. Company with competitive advantage will have always higher earnings. Watch out for the ones above 20% consistently over a long period of time.
Caution- a very high net profit ratio may indicate company has accepted higher risk to make easier money. For example banks make good amount from arbitrage take at @6% and lend @7%. When a disaster looms like sub prime it can plunge to darkness.

Question- is the EPS (pre-tax) is consistently on rise for last ten years?
Hint- the company may not be going through expensive process of change management or even not spending mega bucks on selling, advertisement etc.

Question- does the company have a surplus cash consistently over ten years (cash and cash equivalent divided by total assets). Cross check with low debt as well to rule out loan has been not utilized.
Hint- rule out three scenarios for excess cash balance 1. Sale of asset 2. Temporary pile of asset before usage 3. Sale of shares or debentures

Question: inventory to sales is on rising trend over last ten years?
Hint- this may indicate company is finding profitable ways to increase sales, and this increase has called for increase in inventory, to ensure orders can be honored in time.

Question: does the company show a declining trend of lower percentage of net receivables to sales?
Hint- check this with number of big 5 customers (if available). If you see same customers are there and sales days are going down it would mean company is able to manage oligopoly status and demand lower credit terms from customer.

Question: Current ratio (current assets divided by current liabilities) is consistently less than 1.
Hint: these companies are so strong they easily overcome current liabilities. Check the dividend power or stock buy backs to confirm the earning power.

Question: low asset base (tangible asset).
Hint: check this with debt and earning. This means moat companies doesn’t spend much in replacing assets. Also consistent products, no transformation required in products to stay alive.

Question: does company buy bonds and shares of moat companies?
Hint: two genius thinks alike, this may tell us moat company is putting money in another moat company which will compound earnings better.

Question: check for moderate return on assets with high asset base.
Hint- the premise here is if a company having 40% ROA with 1 Cr asset base will be easily taken over. But some one with 25% ROA and 10K Cr asset base difficult to be bull dozed.

Question: check whether company is using secured loans to make payment for unsecured loans?
Hint- this means I am pledging my assets to pay off debt required for day to day assets. This is not a good sign. For moat company do the reverse.

Question: check whether long term debt is maximum 2-3 times of earnings.
Hint: moat companies don’t need a lot of debt, this is a way to check that.

Question: increasing debt- equity ratio over the years?:slight_smile:
Hint: the logic behind this is moat companies spend a lot of money in buying back shares or pay dividend. That pulls down the equity base, check high debt equity ratio with share buy back or heavy dividend payment (30-40% pay out ratio).

Question: check whether retained earnings growing consistently.
Hint: this means that moat company has made a lot of earnings which are reinvested to business. Confidence of making more compounding, check this with high ROE. Rule out the high retained earnings because of acquisition.

Question: check whether capital expenditure (see cash flow) is less than 30% of net profit.
Hint: moat companies doesn’t pay much for replacing asset. Even if you get a super number like 30 ensure capex to net profit is going down.

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What is Strategy- Revisiting Michael Porter

What differentiate good company with better or better with best is “Competitive Advantage” Investing world for centuries trying to estimate future earnings as that’s their piece of cake. Knowing future can be really uncertain. The investing god Warren Buffett came up with a word “moat” where he described what he feels attributes can protect a company from competition.

But the man who invented the word competitive advantage is Michael Porter often called as living legend, father of modern strategy. He was constantly voted for more than 20 years as world’s top most thinker. Porter defined five forces that define industry and advantage need to be built or to have fend off competition.

Once Howard Marks reiterated, “to all those trying different models, there is only one model that defines competitive advantage and that is Michael Porter framework”.

If you can understand and apply Porter’s framework of competitive advantage you don’t need any moat or boat.

But there is a big problem, Porter didn’t write for investors. His model was meant for business as a whole. Entrepreneurs chased the framework madly, it was not easy to understood. Neither Mr Porter was ready to tweak his ideology. A senior partner from Bain & Co, Joan Margareta took the pain and wrote a book with help of Porter, called as “Understanding Michael Porter”.

Suggested Reading by Michael Porter

  • Competitive Strategy (this is game changer thesis)
  • Competitive Advantage

Both these books were written in 80’s. In 1996 Porter revisited his own framework. Here are the key highlights:

Operational Effectiveness is NOT Strategy

He said according to new world rivals can quickly copy and market position; that’s a half-truth and dangerous. He agrees that some companies have become leaner but don’t get confused between strategy and operational effectiveness.

He calls out for a difference company should have to preserve its uniqueness.

Strategy rests on unique activities

He says strategy is being different, deliberately choosing set of activities to deliver a unique value. He defined strategic needs arise from customer’s needs, customer accessibility, or the variety of company’s product or services.

Sustainable strategic position requires trade offs

He says you are likely to be copied, get ready to amend yourself; abandon a few, mend ways if required. Ultimately your positioning should offer you choice and limit what you can offer.

Fit drives both competitive advantage and sustainability

He brings out inter connectivity between different activities. Differentiate between achieving excellence and combining activities.

Rediscovering strategy

He argues threats from within are bigger than external.

The article was highly acclaimed, more so with the legend revisited his own theory after 12 years. What changed from his previous work, you need to feast on his original books.

“What is Strategy, you can read minute thoughts around his thoughts.

http://www.engr.mun.ca/~amyhsiao/strategy.pdf

In my opinion just one word, moat is Porter….if you can please do and also help me. I am trying to practice for last 15 years without success.

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Hi Suvi,

Fantastic work. You are sharing a wealth of information. Thank you.

A google talk by Pat dorsey on moat is quite interesting

Regards,
Raj

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Yes Raj
You hit with a hammer, one of the guys who spent entire life chasing moat.

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Switching Costs- Meaningful Relationship Between Need and Investments

Note- this is one of my abstract notes based on various learning of basic terms and application.

Switching cost is a type of competitive advantage enjoyed across strategic space:

  • Create an entry barrier
  • While switching suppliers
  • While selecting substitutes
  • For customer when they choose buyers

I always thought could switching cost be a reason for brand loyalty? If yes what will be those attributes which drives the identification process?
Take this scenario I want to buy something now for an old investment and I need compatibility between both new and old. Now my investment can be a physical investment in may be setting up a equipment, setting up a relationship, an informational investment in finding how to use the product, about characteristics, an artificial created investment in buying high priced first unit and then allow subsequent units to buy cheaply. Finally may be a psychological investment.

But the bigger question what is driving me as an individual to create this switching cost:

Need 1: I have equipment and need compatibility. (Like camera with lenses, Razor with blades, water purifier with filter)

Need 2: I have to spend high transaction costs for switching. (One bank account to other, lease against buy)

Need 3: My cost of learning’s to use new brands (soft ware, qwerty key board)

Need 4: I don’t know what the new product or services will be. (gamble of trying new more so at drugs)

Need 5: I have loyalty contracts, which may expire. (reward points, discount coupons)

Need 6: I do have emotional costs of switching. (cigarette brand, mothers cooking!)

Inter relationships of need and investment

If we see I found Need 1 is the only place where we need all sort of investments. That’s the place where need is required with compatibility.
Need 3 (learning) and Need 5 (loyalty contract) are the ones with second highest investment propositions.
Clarification- why switching costs for a bank is not a psychological investment. We need to differentiate here that customer has already made up his mind and ready to switch. He is fed up with something and wants to move on.
Moving forward I wondered whether these needs could be further segmented to:

  • Frequent need
  • Long term need
  • Affordable need
  • Joint need

Once again first need satisfies most of the clear runway.

Practical Application of Need 1

Any Winners?

Water and air purifier business:
Investment: we need a physical investment, information is required to run, machines are artificially increased with price, health consciousness plays a psyche spoiler.

Need segmentation:
Water purifier have to be regularly maintained, required for a long term, affordable as well, and jointly required for family.

Listed Boys- I don’t know!, Air Purifier- ???

Please do let me know whether you can spot any other business. I will also continue to search. Let me know questions if any.

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Thank you sir for providing so much wisdom. Really appreciate.

I have been going through your threads (completed this one and some halfway through your Guru Mantras one) and I think it would take multiple reads to assimilate the wealth of information there.

Thank you again for putting this effort.

No where close to be called sir, still counting leaves on learning tree. :slight_smile:

Knowledge hub like this can work like explosive network effect benefitting
everyone. Key point is network effect doesn’t work unless there is a
critical mass.

So in short we all are critical in this forum or else network effect will
fail. Lets not allow that:).

Thanks for wishes, please do let me know if you have questions.

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