Tuesday, December 8, 2015

Competition & Moats - Part II

In a post a few months back I included the following Warren Buffett quote:

"We like to own castles with large moats filled with sharks and crocodiles that can fend off marauders -- the millions of people with capital that want to take our capital. We think in terms of moats that are impossible to cross, and tell our managers to widen their moat every year, even if profits do not increase every year."

Competition & Moats

Over the longer haul equity investing* mostly comes down to whether a business possesses durable advantages, has attractive economics, and can be bought -- outright or on a per-share basis -- at the right price.

Buffett once wrote:

"Severe change and exceptional returns usually don't mix. Most investors, of course, behave as if just the opposite were true. That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change."

In fact, in enough cases to matter, businesses in rapidly changing/expanding industries -- usually with lots of growth potential -- cause investors to focus on the upside and, as a result, they tend pay a high multiple of earnings that, all risks considered, more than reflects the potential with too little consideration for lesser possibilities.

Never mind the worst possible outcomes.

The most dynamic industries might promise lots of growth but can also attract lots of competition, fresh capital, and have rules that are yet to be written. A new technology can naturally prove to be a great benefit for the world. Yet that's hardly a guarantee the capitalists involved will end up being justly rewarded. Look no further than the auto manufacturers and airlines for just two good examples. What's been better for the world those two industries or tobacco? What's generally been the better long-term investment?**

Some industries end up with multiple participants who build sustainable advantages. Others tend to have one big winner and lots of losers. For one it's a feast...for the rest it's famine. Worst of all some industries never seem to develop sound economics even for the so-called winners. With such unpredictability, identifying a sound investment beforehand -- with all risks and alternatives carefully considered -- without paying too much or making big misjudgments is easier said than done. This might makes things exciting but also inherently unpredictable with wide range of outcomes. Not exactly compatible with balancing risk and reward. In other words, lots of upside to be sure but also lots of downside.

Those who don't appropriately weigh the full range of outcomes tend to overpay for the privilege of ownership.

Insufficient margin of safety.

This is, at the very least, worthy of some consideration the next time an investment with exciting growth prospects comes along. Investing well is partly dependent on avoiding the big and costly errors.

It's worth emphasizing -- and I've covered variations of this in a number of prior posts -- growth is not the emphasis here. Growth can naturally be a fine thing under the right circumstances. Yet some seem will to assume that all growth is good growth. Well, at times, the importance of growth can be more than just a bit overrated.

There are certainly high growth businesses that end up building durable advantages over time.

Many examples of this exist from the past twenty years alone and, no doubt, there will be many more in the coming decades.

The tough part is figuring out how to reliably identify them beforehand and acquiring shares at an attractive enough price. That'd be attractive enough to own long-term and protect against misjudgments, the unknown, and the unknowable. In other words, that shares can be bought below what they're currently worth and produce a more than satisfactory long-term result. Also, if the shares do need to be sold a long time down the road (a "forever" holding period might be preferred but isn't always possible or even wise), a merely decent price compared to future -- much higher -- per share intrinsic value should be all that is required. Market participants who knowingly buy an expensive stock with the hope being to sell as it gets even more expensive have an entirely different emphasis. Market prices are not in a participants control. So it's unwise to be dependent on unusually high prices to achieve expected results. Buffett once said:

"Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results."

Now, it's not as if investing in something with exciting prospects can't work out extremely well.

For some investors -- due to their specific background and abilities -- investing in such things will be the appropriate place to risk their capital. It's just important to know when investing in such things doesn't really play to one's own strengths.

Those who build the next transformational business naturally deserve lots of respect. That doesn't necessarily mean it makes sense to invest in their efforts. Admiration from a distance can be, depending on circumstances and abilities, the right way to go.

An investment decision-making process must have enough discipline built in to prevent large and permanent losses of capital.

It's knowing what one knows as much as what one does not.

Some will choose to focus on identifying the next big winner.

Efforts to reduce costly errors often deserve more attention.

Once again...easier said than done.

Sometimes, rapidly changing competitive dynamics will result in serious damage to a business that once seemed like an invincible powerhouse with a fortress built around them.

Other times, even if not completely unaffected by the changing technological and competitive landscape, the business will adapt and continue to do just fine.

Figuring this out, at least for me, is what makes investing so challenging and worthwhile in the first place.

Some other things worth considering:

One or two big misjudgments can more than offset what's otherwise worked out well.

The relationship between risk and reward isn't as straightforward as some seem to think. Higher risk investments don't represent some kind of direct path to higher returns. Instead, they're more likely to be related to a wider range of outcomes.

A recipe for both large and unnecessary mistakes as well as possible big gains.

Risk and reward is not necessarily correlated in a positive manner.

Finding a business with rapid growth prospects -- along with core economics likely to remain sound for a very long time -- that can be bought at the right price (a plain discount to estimated value) isn't impossible but it's easy to underestimate what the worst possible outcomes could be.

Anyone can, after the fact, explain why something worked as an investment.

Only after the fact is it usually "obvious".

Cognitive and other biases -- in the context of investing -- are not necessarily just someone else's problem.

Adam

* The emphasis here NOT being on speculation. Instead, it's what an asset can produce over a very long time horizon. It's on whether something can be bought now and produce a satisfactory result primarily based on how intrinsic value changes over time. Those who try to guess what stock prices might do -- whether using fundamental analysis or not -- over the next few years or less are attempting to do something I have no view on whatsoever. There's nothing inherently wrong with speculation but it just doesn't have all that much in common with investment.
** This historical reality reveals little about the future: Different times, different competitive dynamics, different market prices....among other things. The point being that expecting what's good for the world to be directly correlated with future investment returns can be a big mistake.
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