Building A Moat
So then, how does a company remain attractive for an extended period? By possessing a sustainable competitive advantage, or moat, as Buffett would call it. Such may materialize in several different forms.
Sometimes it’s a brand name (think Coke), while other times, it’ll be a patent (drug companies) or a network effect (Facebook and Google).
Let’s take Google as our example: they’ve earned a return on capital in the high teens over the last decade. They have had a near-identical sum on equity because they have had a minuscule amount of debt during most of this period. Because they have more searches performed than competing search engines (with a 92.71% market share according to statcounter.com), their algorithms can endlessly improve more quickly than a smaller competitor. Such has cemented Google as the best search engine-per the American Customer Satisfaction Index. Google scored highest among its competitors for User Satisfaction-which keeps the trend going.
A business would need to be a fool to skimp and advertise with Microsoft’s Bing with only a fraction of the audience (2.73% market share). Such is what enables Google to fend off the intruders and continually earn healthy returns. How has this worked out, you ask? Over the last decade, their income has increased more than four-fold (pre-tax income of nearly $40 billion in 2019), and their investors have received a 330% return. Google has outperformed the rise in both the Nasdaq and the S&P 500.
A Simple Comparison
Contrast the economics of Google with Posco, the third-largest steel producer in the world, headquartered in South Korea. With little differentiation between producers, steel is generally a commodity type business. As a result, Posco has earned roughly a 5% return on invested capital over the past decade. Their business demands enormous capital investments to maintain the plant and equipment necessary to remain competitive and provide only meager returns on said investment. That is an example of mediocrity, if not worse.
So how have their investors faired?
Sales have gone nowhere, profits have decreased in the decade since 2010, and shareholders have seen a decrease in their holdings price.
Even The Best Company Will Not Justify An Infinite Price.
McDonald’s has a long history of earning excellent returns on invested capital due to its brand name and scale. Such provides them enormous leverage with their suppliers. During the early 1970s, the market recognized much of its potential and bid up its share price. At the height of the “Nifty Fifty” (of which the company was a member) in January of 1973, McDonald’s sold for 86 times earnings, at about $0.96 per share adjusted for splits.
As investors came to their senses, the price plummeted 68% to just $0.30 in 1974. It took until mid-1982 to break the high price set in ‘73. That’s more than 9-years!
No matter how excellent a company is, paying too high of a price is never a good idea.
Conclusion And A Lesson.
“We should invest like my friend buys his cars. Find wonderful businesses that we’d love to own, and only then patiently wait until, by the stupidity of the markets, someone will sell us a stake at a fantastic price.”