Michael Mauboussin is the author of The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing (Harvard Business Review Press, 2012), Think Twice: Harnessing the Power of Counterintuition (Harvard Business Press, 2009) and More Than You Know: Finding Financial Wisdom in Unconventional Places-Updated and Expanded (New York: Columbia Business School Publishing, 2008). More Than You Know was named one of “The 100 Best Business Books of All Time” by 800-CEO-READ, one of the best business books by BusinessWeek (2006) and best economics book by Strategy+Business (2006). He is also co-author, with Alfred Rappaport, of Expectations Investing: Reading Stock Prices for Better Returns (Harvard Business School Press, 2001).
Visit his site at: michaelmauboussin.com/
Dov Gertzulin's DG Capital is having a strong year. According to a copy of the hedge fund's letter to investors of its DG Value Partners Class C strategy, the fund is up 36.4% of the year to the end of June, after a performance of 12.8% in the second quarter. The Class C strategy is Read More
Michael Mauboussin - Measuring The Moat
“The most important thing to me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.” Warren E. Buffett - Linda Grant, “Striking Out at Wall Street,” U.S. News & World Report, June 12, 1994
- Sustainable value creation is of prime interest to investors who seek to anticipate expectations revisions.
- This report develops a systematic framework to determine the size of a company’s moat.
- We cover industry analysis, firm-specific analysis, and firm interaction.
Corporate managers seek to allocate resources so as to generate attractive long-term returns on investment. Investors search for stocks of companies that are mispriced relative to expectations for financial results embedded in the shares. 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), value growth duration, and T.1 Despite the unquestionable significance of the longevity dimension, researchers and investors give it insufficient attention.
How is sustainable value creation distinct from the more popular notion of 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 an economic return that is higher than the average of its competitors.2
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. Naturally, these concepts are closely linked. Sustainable value creation is rare, and sustainable competitive advantage is even rarer.
Competitive Life Cycle
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:
- Innovation. Young companies typically realize a rapid rise in return on investment and significant investment opportunities. Substantial entry into and exit out of the industry are common at this point in the life cycle.
- Fading returns. High returns attract competition, generally causing economic returns to move toward the cost of capital. In this phase, companies still earn excess returns, but the return trajectory is down. Investment needs also moderate, and the rate of entry and exit slows.
- Mature. In this phase, the market in which the companies compete approaches competitive equilibrium. As a result, companies earn a return on investment similar to the industry average, and competition within the industry ensures that aggregate returns are no higher. Investment needs continue to moderate.
- Subpar. Competitive forces and technological change can drive returns below the cost of capital, requiring companies to restructure. These companies can improve returns by shedding assets, shifting their business model, reducing investment levels, or putting themselves up for sale. Alternatively, these firms can file for bankruptcy to reorganize the business or liquidate the firm’s assets.
Regression toward the mean says that an outcome that is far from average will be followed by an outcome that has an expected value closer to the average. There are two explanations for regression toward the mean in corporate performance. The first is purely statistical. If the correlation between cash flow return on investment (CFROI®?) in two consecutive years is not perfect, there is regression toward the mean.
Think of it this way: there are aspects of running the business within management’s control, including selecting the product markets it chooses to compete in, pricing, investment spending, and overall execution. Call that skill. There are also aspects of the business that are beyond management’s control, such as macroeconomic developments, customer reactions, and technological change. Call that luck. Whenever luck contributes to outcomes, there is regression toward the mean. If year-to-year CFROIs are highly correlated, regression toward the mean happens slowly. If CFROIs are volatile, causing the correlation to be low, regression toward the mean is rapid.
The second explanation for regression toward the mean is that competition drives a company’s return on investment toward the opportunity cost of capital. This is based on microeconomic theory and is intuitive. The idea is that companies that generate a high economic return will attract competitors willing to take a lesser, albeit still attractive, return. Ultimately, this process drives industry returns toward the opportunity cost of capital. Researchers have documented the accuracy of this prediction.3 Companies must find a way to defy these powerful competitive forces in order to achieve sustainable value creation.
Recent research on the rate of regression reveals some important observations. First, the time that an average company can sustain excess returns is shrinking. This phenomenon is not relegated to high technology but is evident across a wide range of industries.4 This reduction in the period of sustained value creation reflects the greater pace of innovation brought about in part by increased access to, and utilization of, information technology.
Second, the absolute level of returns and the level of investment are positively related to the rate of fade.5 A company that generates a high return on investment while investing heavily signals an attractive opportunity to both existing and potential competitors. Success sows the seeds of competition.
Why is sustainable value creation so important for investors? To start, investors pay for value creation. Exhibit 2 looks at the S&P 500 since 1961 and provides a proxy for how much value creation investors have been willing to pay for. We 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.6 We then attribute any value above the steady-state to expected value creation.
The exhibit shows that 40 percent of the value of the S&P 500 today reflects anticipated value creation, above the average of the last 55 years. Following a sharp drop in 2011 to a level near a 50-year low, the expectations for value creation have risen to a level modestly above the long-term average.
More significant, 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.
Companies and investors use competitive strategy analysis for two very different purposes. Companies try to generate returns above the cost of capital, while investors try to anticipate revisions in expectations. Investors should anticipate earning a market return, adjusted for risk, if a company’s share price already captures its prospects for sustainable value creation. But companies that can create value longer than the market expects generate excess returns with volatility that is lower than expected.7
We will spend most of our time trying to understand how and why companies attain sustainable value creation in product markets. But we should never lose sight of the fact that our goal as investors is to anticipate revisions in expectations. Exhibit 3 shows the process and emphasizes the goal of finding and exploiting expectations mismatches.
See the full PDF below.