Dear Fellow Investors:
Rarely has anything been said about business which is more brilliant. Or at least that’s our take on a quip from one of my favorite movies, O Brother Where Art Thou. In the movie, a music producer showed up at the radio station where the The Soggy Bottom Boys recorded their single, “Man of Constant Sorrow,” which had become an overnight smash hit. He announced to the blind man running the station, “We’ve got to find those boys and sign them to a contract before the competition does!” The blind man leans back and says, “O, yes, we got to beat that competition.”
We contend that competition is the enemy of high and sustainable profitability and the reducer of the duration or life of a business. For this reason our number two criteria for stock selection is how strong a company’s competitive advantage is. Some also call this, “wide moat.” The term derives from the moat around a castle in medieval times that kept potential conquering armies at bay. At Smead Capital Management, we believe that understanding how strong your competitive advantage is offers a way to obtain greater vision about the long-term future of a company. We will cover a few case studies to help us understand some of the art associated with strong competitive advantage and wide moats.
We maintain that one of the easiest ways to obtain a strong competitive advantage is to do something which nobody else wants to do. Morticians and cigarette manufacturers would be examples of occupations and businesses which benefit from a strong competitive advantage, namely that their business is abhorrent to many people and entrepreneurs. Similarly, we see a near complete consensus that the newspaper business is dead in the long run. If a company is out of favor, fits our other seven criteria and maintains a strong competitive advantage, we’re interested. This is why we own Gannett Co., Inc. (NYSE:GCI), which owns 84 daily newspapers and 40 network-affiliated TV stations. We think Gannett Co., Inc. (NYSE:GCI)’s business is well defended from competition in the advertising business and allows entry at a low price-to-earnings ratio (P/E).
A second way to generate a strong competitive advantage—we think—is to be in a business that requires massive size. Think of the duopoly shared by The Boeing Company (NYSE:BA) and Airbus. Who else do you know building commercial airliners these days? Every 10 to 15 years they have to commit billions of dollars of capital to design and build airplanes which won’t exist for years. We contend that this massive capital outlay prevents anybody new from emerging as a major aircraft manufacturer. Pharmaceuticals and biotech are other industries which require large scale, but do not face the same cyclicality as airlines. It takes about one billion dollars of capital (on average) to create a blockbuster drug and immense manufacturing and distribution capabilities to sell it around the world.
A third way we believe you can strengthen your competitive advantage or widen your moat is to go through tough times in the industry. It seems that many of our stock picking competitors fail to realize that the same thing that causes short-term difficulty in an industry can be a big creator and widener of a company’s moat. In the pharmaceutical industry, the era between 2004 and 2012 was marked by huge lawsuits (Vioxx), demeaning national politics, an especially scrutinous regulatory environment and the potential loss of hugely profitable patented medicines. Nobody new emerged in the industry and the largest players consolidated via mergers. Investors attached very low P/E ratios to the industry, well representing the short-run difficulties. The moat got better, which brightens the long-term future of the business, but you got a much lower stock price to work with if you were a long-duration investor.
A fourth way to develop a strong competitive advantage, in our view, is branding. We like speculating about putting 100 people in a room and naming a generic product category. Which company would come to people’s mind? Any company which comes into the head of 90% of the people in the room has an incredible moat. A few examples would be helpful. If you said “tax preparation,” we would not be surprised to hear most everyone say “H & R Block Inc (NYSE:HRB)” (HRB). If you said “gourmet coffee,” folks would probably answer “Starbucks Corporation (NASDAQ:SBUX)” (SBUX). If you said “wholesome family entertainment,” they would almost certainly say “The Walt Disney Company (NYSE:DIS)” (DIS).
Warren Buffett highlights a fifth way that a company develops a strong competitive advantage: the “stickiness” of the customers. Are they intensely addicted and endeared to the company? Or is it very hard to extricate yourself from the relationship the customer has with the business? We think Starbucks has addicted customers, while the customers of major banks like Bank of America Corp (NYSE:BAC), Wells Fargo & Co (NYSE:WFC) and JPMorgan Chase & Co. (NYSE:JPM) are governed by inertia. To us, the process of changing banks is an incredibly painful experience which keeps the customers in place. Our view is that sticky customers give you great price flexibility. Buffett likes to think of a wonderful business as having a mirror on the wall. When you go up to the mirror and ask it if you should raise prices this fall, the mirror answers, “Why wait?” Netflix, Inc. (NASDAQ:NFLX) just announced today that they will pay more to Comcast Corporation (NASDAQ:CMCSA) for high-speed access. It sounds like the mirror on the wall is working in Brian Roberts’s office.
The last thing we’d like to mention with regards to strong competitive advantage and wide moats is the nature of the young entrepreneurial class. We estimate that every day thousands of brilliant people try to invent a product or service which will be a category killer in technology. Therefore, we believe most technology companies have very indefensible moats. On the other hand, how many super smart young people want to create a new tax preparation company or the world’s best morgue or top what Walt Disney did by starting his wholesome family entertainment enterprise? Mark Zuckerberg created a company that any bright young person would have loved to have invented, but how many aspire in deposit banking and mortgage lending? Being unhip protects the high and sustainably profitable business from competition.
The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
This Missive and others are available at smeadcap.com