Warren Buffett consistently emphasizes that he wants to buy businesses with prospects for sustainable value creation. He suggests that buying a business is like buying a castle surrounded by a moat and that he wants the moat to be deep and wide to fend off all competition. Economic moats are almost never stable. Because of competition, they are getting a little bit wider or narrower every day. A recent report, Measuring the Moat, by Michael J. Mauboussin and Dan Callahan of Credit Suisse Group AG (NYSE:CS), develops a systematic framework to determine the size of a company’s moat.
Moat: Dimension of sustainable value creation
Corporate managers seek to allocate resources so as to generate attractive long-term returns on investment. Investors search for stocks of companies that are mis-priced relative to embedded financial expectations. In both cases, sustainable value creation is of prime interest.
What exactly is sustainable value creation? We can think of it in two dimensions. First is the magnitude of returns in excess of the cost of capital that a company does, or will, generate. Magnitude considers not only the return on investment but also how much a company can invest at a rate above the cost of capital. Growth only creates value when a company generates returns on investment that exceed the cost of capital.
The second dimension of sustainable value creation is how long a company can earn returns in excess of the cost of capital. This concept is also known as fade rate, competitive advantage period (CAP) and value growth duration.
Why is sustainable value creation so important for investors?
According to Mauboussin and Callahan, investors pay for value creation. Exhibit below looks at the S&P 500 (INDEXSP:.INX) since 1961 and provides a proxy for how much value creation investors have been willing to pay for. They establish a steady-state value by capitalizing the last four quarters of operating net income for the S&P 500 by an estimate of the cost of equity capital. They then attribute any value above the steady-state to expected value creation. The exhibit shows that currently one-fifth of the value of the S&P 500 reflects anticipated value creation, a low number compared to the last 50 years. Since 2010, the level of anticipated value creation has remained below the historical average of one-third, as earnings have recovered and interest rates have remained low.
More significantly, sustained value creation is an important source of expectations revisions. There is a crucial distinction between product markets and capital markets. Companies try to understand the industry and competitive landscape in their product markets so as to allocate resources in a way that maximizes long-term economic profit. Investors seek to understand whether today’s price properly reflects the future and whether expectations are likely to be revised up or down. Exhibit below shows the process and emphasizes the goal of finding and exploiting expectations mismatches.
What dictates a company’s destiny?
Peter Lynch, who skillfully ran Fidelity’s Magellan mutual fund for more than a decade, quipped that investors are well advised to buy a business that’s so good that a dummy can run it, because sooner or later a dummy will run it. Lynch’s comment begs an important question: What dictates a firm’s economic returns? Mauboussin and Callahan are not asking what determines a company’s share price performance, which is a function of expectations revisions, but rather its economic profitability.
Before they answer the question, they can make some empirical observations. The top panel in the below Exhibit shows the spread between CFROI and the cost of capital for 68 global industries, as defined by MSCI’s Global Industry Classification Standard (GICS), using median returns over the past five fiscal years. The sample includes more than 5,500 public companies. We see that some industries have positive economic return spreads, some are neutral, and some don’t earn the cost of capital.
The bottom panel of this Exhibit shows the spread between CFROI and the cost of capital for companies in three industries: one that creates value, one that is value neutral, and one that destroys value. The central observation is that even the best industries include companies that destroy value and the worst industries have companies that create value. That some companies buck the economics of their industry provides insight into the potential sources of economic performance. Industry is not destiny.
Finding a company in an industry with high returns or avoiding a company in an industry with low returns is not enough. Finding a good business capable of sustaining high performance requires a thorough understanding of both industry and firm-specific circumstances.
See the full report here.