16 December 2002, Michael Mauboussin ‘Measuring The Moat’
Michael Mauboussin is considered an expert in the field of behavioral finance and has some famous books on the topic including, Think Twice: Harnessing the Power of Counterintuition and More More Than You Know: Finding Financial Wisdom in Unconventional Places.
Ideally, corporate managers try to allocate resources so as to generate attractive longterm returns on investment. Similarly, investors try to buy the stocks of companies that are likely to exceed embedded financial expectations. In both cases, sustainable value creation is of prime interest.
What exactly is sustainable value creation? We can think of it across two dimensions. First is the magnitude of returns in excess of the cost of capital that a company can, or will, generate. Magnitude considers not only the return on investment but also how much a company can invest at an above-cost-of-capital rate. Corporate 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), value growth duration, and T.
Despite the unquestionable significance of this longevity dimension, researchers and investors give it scant attention.
How does sustainable value creation differ from the more popular sustainable competitive advantage? A company must have two characteristics to claim that it has a competitive advantage. The first is that it must generate, or have an ability to generate, returns in excess of the cost of capital. Second, the company must earn a higher rate of economic profit than the average of its competitors.
As our focus is on sustainable value creation, we want to understand a company’s economic performance relative to the cost of capital, not relative to its competitors (although these are intimately linked, as we will see). If sustainable value creation is rare, then sustainable competitive advantage is even more rare, given that it requires a company to perform better than its peers.
We can visualize sustainable value creation by looking at a company’s competitive life cycle. (See Exhibit 1.) Companies are generally in one of four phases (see Appendix B for a breakdown by industry):
- Innovation. Young companies typically see sharp increases in return on investment and significant investment opportunities. This is a period of rising returns and heavy investment.
- Fading returns. High returns attract competition, generally causing economic returns to gravitate toward the cost of capital. In this phase, companies still earn excess returns, but the return trajectory is down, not up. Investment needs also moderate.
- Mature. In this phase, the product markets are in competitive equilibrium. As a result, companies here earn their cost of capital on average, but competition within the industry assures that aggregate returns are no higher. Investment needs continue to moderate.
- Subpar. Competitive forces often drive returns below the cost of capital, requiring companies to restructure. These companies often improve returns by shedding assets, shifting their business model, reducing investment levels, or putting themselves up for sale. Alternatively, these companies can distribute their assets through a bankruptcy filing.
One of the central themes of this analysis is that competition drives a company’s return on investment toward the opportunity cost of capital. This theme is based on microeconomic theory and is quite intuitive. It predicts that companies generating high economic returns will attract competitors willing to take a lesser, albeit still attractive, return which will drive down aggregate industry returns to the opportunity cost of capital. Researchers have empirically documented this prediction.
To achieve sustainable value creation, companies must defy the very powerful force of reversion to the mean. Recent research on the rate of mean reversion reveals a couple of important points. First, the time that an average company can sustain excess returns is shrinking.
This reduction in sustainable value creation reflects the greater pace of innovation and a shift in the composition of public companies (i.e., today there are more young public companies than 25 years ago). Second, reinvestment rates and the variability of economic returns help explain the rate of fade.
For example, a company that generates high returns while investing heavily signals an attractive opportunity to both existent and potential competitors. Success sows the seeds of competition.