Measuring the moat michael mauboussin

Measuring Moat Strength Relative To Competitors

Let's apply the lessons learned from the materials to your place of work. How secure is Wells Fargo's Moat? Comment specifically on one of the following five areas of analysis that you feel are most critical in defining the relative strength of your Moat: Porter’s Five Forces, Barriers to Entry, Rivalry, Disruption and Disintegration, and Brand. In addition, since Moat trends are always fluid, which direction is your Moat moving? Is it becoming wider or narrower?

CONTENTS

MOAT ANALYSIS AND VALUE CREATION: Weeks 1-3 .................................................................... 2

VALUE INVESTING AND GROWTH INVESTING: WEEKS 4-10 ...................................................... 4

ENTERPRISE RISK MANAGEMENT: WEEK 6 .................................................................................... 6

FINANCIAL STATEMENT ANALYSIS: WEEK 9 ................................................................................. 8

* Material in these checklists is taken from Credit Suisse: “Measuring the Moat” and from

original sources for use by JWI-531 students only.

2

MOAT ANALYSIS AND VALUE CREATION: WEEKS 1-3

Why Moats Matter: Guiding Principles of Morningstar’s Equity Research

 How Can We Identify Which Businesses Are Great?

 When Is the Best Time to Invest in Great Businesses?

What Makes a Moat?

 Sustainable Competitive Advantages

 Valuation

 Margin of Safety

Moat Sources - Five Key Considerations for Moat Trends

 Intangibles

 Cost Advantage

 Switching Costs

 Network Effect

 Efficient Scale

Moat Valuation

 Cost of Capital and Returns on Capital

 Morningstar’s Valuation Approach

 Ratio Analysis – ROIC, Price/Earnings, Price/Sales, Price/Cash Flow, and Price/Book value

 Forecasting Future Free Cash Flows

 The Morningstar Rating ™ for Stocks

 Fair Value Uncertainty and Cost of Equity

Putting Moat and Valuation to Work: Portfolio Strategies

 Wide Moat Focus Index

 The Tortoise and Hare Portfolios

Analysis Overview

 In what stage of the competitive life cycle is the company?

 Is the company currently earning a return above its cost of capital?

 Are returns on invested capital increasing, decreasing, or stable? Why?

 What is the trend in the company’s investment spending, including mergers and acquisitions?

Lay of the Land

 What percentage of the industry does each player represent?

 What is each player’s level of profitability?

 What have the historical trends in market share been?

 How stable is the industry?

 How stable is market share?

 What do pricing trends look like?

 What class does the industry fall into: fragmented, emerging, mature, declining, international, network, or hypercompetitive?

Porter’s Five Forces

 How much leverage do suppliers have?

 Can companies pass price increases from their suppliers on to their customers?

 Are there substitute products available? Is there Product differentiation?

 Are there switching costs? Is there a competitive advantage through cost leadership, or focus

 How much leverage do buyers have? How informed are the buyers?

Boston Consulting Group Approach

 Historical emphasis: experience curve, product life cycle, product portfolio balance

 Impact of the Internet and other innovations

 Performance measurements - cash flow return on investment (CFROI)

Barriers to Entry

 What are the rates of entry and exit in the industry?

 How will the incumbents react to the threat of new entrants?

 What is the reputation of incumbents?

 How specific are the assets?

 What is the minimum efficient production scale?

 Does the industry have excess capacity?

 Is there a way to differentiate the product?

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 What is the anticipated payoff for a new entrant?

 Do incumbents have pre-commitment contracts?

 Do incumbents have costly licenses or patents?

 Are there benefits from the learning curve?

Rivalry

 Is there pricing coordination?

 What is the industry concentration?

 What is the size distribution of firms?

 How similar are the firms in incentives, corporate philosophy, and ownership structure?

 Is there demand variability?

 Are there high fixed costs?

 Is the industry growing?

Disruption and Disintegration

 Is the industry vulnerable to disruptive innovation?

 Do new innovations foster product improvements?

 Is the innovation progressing faster than the market’s needs?

 Have established players passed the performance threshold?

 Is the industry organized vertically, or has there been a shift to horizontal markets?

Firm Specific Analysis

 Does the analysis of the value chain reveal what the firms does differently from its rivals?

 Does the firm have production advantages? Is there instability in the business structure? Is there complexity requiring know-how or coordination capabilities? How quickly are the process costs changing?

 Does the firm have any patents, copyrights, trademarks, etc.?

 Are there economies of scale? What does the firm’s distribution scale look like? Are assets and revenue clustered geographically? Are there purchasing advantages with size? Are there economies of scope? Are there diverse research profiles?

 Are there consumer advantages? Is there habit or horizontal differentiation? Do people prefer the product to competing products? Are there lots of product attributes that customers weigh? Can customers only assess the product through trial? Is there customer lock-in? Are there high switching costs?

 Is the network radial or interactive?

 What is the source and longevity of added value?

 Are there external sources of added value (subsidies, tariffs, quotas, and competitive or environmental regulations)?

Firm Interaction—Competition and Coordination

 Does the industry include complementors?

 Is the value of the pie growing because of companies that are not competitors? Or, are new companies taking share from a pie with fixed value?

Brands

 Do customers want to “hire” the brand for the job to be done?

 Does the brand increase willingness to pay?

 Do customers have an emotional connection to the brand?

 Do customers trust the product because of the name?

 Does the brand imply social status?

 Can you reduce supplier operating cost with your name?

4

VALUE INVESTING AND GROWTH INVESTING: WEEKS 4-10

Value Investing

 Value Investing and Two Essential Principles - It’s Like Buying Christmas Cards in January

 P/E averages, avoid temptations

 Does Value Investing Really Work?

 Performance of High versus Low P/E stocks

 Performance of High versus Low Market-to-Book Stocks

 The Power of Multiple Variables

Growth Investing

 How to Identify Growth Stocks

 Importance of Track Record: Sales and Earnings

 Is There Potential to Grow Sales and Earnings for Several Years?

 How Are Relations with Employees?

 How Does the Company Respond to Challenges?

 Is Management Quality Excellent?

 How Important Are Profit Margins?

 What Is the Company’s Achilles’ heel?

Intrinsic Value

 When to Buy Any Stock: Consider Margin of Safety

 The Buffett Investing = Value + Growth

 Value Plus Growth

Risk and Volatility: How to Think Profitably about Them

 Risk and Return: Holding Period impact

 Volatility Offers Opportunities. Volatility is a great time to buy low or sell high

 More on Downside Risk

Why Hold Cash: Liquidity Brings Opportunities

 Liquidity and the Opportunities it brings

 Berkshire’s Investments in Convertibles

Diversification: How Many Baskets Should You Hold?

 Diversification in your portfolio

 How Many Stocks Should You Hold?

 Philip Fisher Warns against Too Much Diversification

 Diversification and “Diworsification”

When to Sell

 Turnover of Berkshire’s Equity Portfolio: Why Buffett Holds Almost Forever

 Two Main Reasons to Sell

How Efficient Is the Stock Market?

 Can I Make Money in the Stock Market?

 Most Academics Favor Market Efficiency Recent Evidence on Market Inefficiency Conclusions

Arbitrage and Hedge Funds

 Arbitrage in Merger Deals

 An Example of a Successful Arbitrage Deal by Buffett

 Long-Term Capital Management: The Story of a Hedge Fund and Berkshire Hathaway

 Should You Invest in Hedge Funds or Private Equity Funds?

Widen the Moat

 What is the profitability of Monopolies?

 Dominance Does Not Mean High Profits

 How to Look for Monopolies

 Do Not Sell a Monopoly in a Hurry

Who Wins in Highly Competitive Industries?

 Insurance example: Insurance is a Commodity Business Like Retailing

 Two Main Characteristics of a Leader: Low Cost and Customer Satisfaction

 How Do Companies Keep Costs Low?

Property, Plant, and Equipment: Good or Bad?

 Capital Intensity

 Capital Intensity and Management Quality

Key to Success: ROE and Other Ratios

 ROE: Return on Equity. The underlying Performance of a Business

 ROA: Return on Assets. Some companies create more value with the assets they have.

Accounting Goodwill: Is It Any Good?

 Accounting Goodwill and Its Economic Value

 Goodwill and Earnings

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 Goodwill and Profitability of Acquired Businesses

Behavioral Finance

 Behavioral finance tells us that investors always don’t behave rationally.

 When combined with overconfidence, anchoring and herding can contribute to market bubbles.

 Examine Your Buying and Selling Patterns: Can You Change Yourself? How Psychology May Help You? How to Think about Psychological Biases?

 Herding: The assumption by many is that others have better information than ourselves and we should follow another investor’s lead instead on our own rationale. This can be a costly mistake for many as this type of thinking only adds to the panic inside of a market bubble.

 Bigger Fool Theory: States that investors periodically loose site of the long run nature of the stock as investment and forget that in order to sell a stock at a profit, one must find a buyer who will pay a higher price.

 Anchoring bias: describes how we associate past performance to future predictions. While recent and past events can give us an idea of what to expect, this is in no way indicative of what the future will bring. The addition of our own over confidence in our ability to predict makes this an issue.

How to Learn from Mistakes

 Mistakes versus Bad Luck: mistakes are a result of effort

 Learning from Mistakes: As managers, mistakes makes us better managers

 Mistakes of Commission and Mistakes of Omission

Dividends: Do They Make Sense in This Day and Age?

 Why does Berkshire Not Pay Dividends?

 Example of Microsoft and a Special Dividend

Should You Invest in Companies That Repurchase Their Own Shares?

 Share Repurchasing Is Good News

 Share Repurchases by Companies in Which Berkshire Has Invested

 Why Doesn’t Berkshire Repurchase Its Own Shares?

Corporate Governance: Employees, Directors, and CEOs

 Employee Compensation at Berkshire

 Compensation for Directors and Executive Officers

 What Is Wrong with Compensation through Stock Options?

 How to Identify Good CEOs or Other Senior Managers

Large Shareholders: They Are Your Friends

 Founder Control Matters

6

ENTERPRISE RISK MANAGEMENT: WEEK 6

Financial Risks

 Price – is the margin on products sufficient to meet operating expenses and generate a profit? Are prices being pushed up or down by competition or customers?

 Liquidity – Is there positive cash flows and ability to meet investing, operational and cash flows? Check Statement of Cash Flows

 Credit Worthiness – compare credit rating amongst firms

 Valuation Risk – does the company’s stock value have high or low volatility

 Business model – is the company hedging for financial risks such as foreign currency?

 Taxation Risk - taxes can factor into a business model, products or locations.

 Interest Rate Risk: cash flows decline when interest rates rise.

 Downgrade Risk: is there a risk that agencies will downgrade the ratings. This might be an indication that the issuer company might default in the future.

 Inflation Risk: costs or revenues can be impacted by changes in inflation

 Default/Credit Risk: Does the company have any issues in making interest and principal payments. Default risk is inversely related to credit quality.

 Currency Exchange (Denomination) Risks: For example: If we purchase a corporate bond denominated in Euros, and if Euro value falls relative to US dollar, then we will lose money even if the company does not default on its bonds.

External Risks

 Regulatory: are regulations or tax laws changing the business model?

 Legal: are there large pending lawsuits?

 Investor Relations: are there many or few large investors? Are investors demanding change in the management?

 Competitors: Is the industry highly competitive where the products and services are a commodity, or an

oligopoly, or significant product/services differentiation?

 Financial Markets: Are there sources for borrowing of funds, issuance of bonds

 Catastrophic Loss: is there the potential for large losses? For example, patents expiring? Large insurance claims?

 Sovereign/Political Risk: is the company exposed to country risks in its international operations?

Strategic Risks

 Market Bubbles: Prices climb rapidly to heights that would have been considered extremely unlikely before the run –up. The volume of trading is much higher than past volume. Many new investors enter the market (speculators). Prices suddenly fall, leaving behind the new investors with heavy losses.

 Leadership: is there poor leadership, or loss of leaders due to death or illness?

 Strategic and Tactical Alignment: are the tactical initiatives going in the same direction as the strategy?

 Planning: what is the quality of the financial forecasts?

 Communication: is management able to properly communicate the strategy and risks?

 Business Model: is the company maximizing the core value drivers?

 Reputation risk: is the firm exposed to activities that can damage its reputation with consumers or business partners?

Operational risks

 Product Pricing: are margins too low? Is the market so competitive that prices cannot be increased?

 Customer: is the company dependent of a few large clients? How does the 80/20 rule apply to the client base?

 Human Resources: are there issues in hiring resources domestically, internationally? Are staff costs competitive?

 Product Development: is the firm investing in R&D? How does it compare to the competition?

 Supply Chain: does the firm have advantages in the buying, building, delivering and stocking inventory?

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 Business Interruption: does the firm have business continuity plans to ensure mission critical activities continue?

 Compliance: is the firm meeting regulatory requirements?

 Audit: is the firm meeting internal and external auditing requirements?

Information Risks

 Performance Measurement: are the right revenue and costs activities being monitored and managed?

 Budget and Planning: is forecasting realistic and relative to internal and external factors?

 Accounting Information: is accounting data available in a timely and consolidated manner?

 Financial Reporting: is the reporting being done in accordance to GAAP and IFRS and meeting all disclosure requirements?

Technology Risks

 Financial systems: are the financial applications capable of processing the right data and producing the proper management and financial reports?

 Access: are there risks of external hacking and the stealing of sensitive or financial data?

 Availability: do the financial systems have disaster recovery and business continuity plans?

 Infrastructure: is the age of the technology mean large and costly expenditures in the near future?

8

FINANCIAL STATEMENT ANALYSIS: WEEK 9

Assess the Quality of the financial statements

 Form 10-K Annual Report

 Proxy Statements

 Prospectus or Registration Statement

 Industry Analyst Ratings

 Shareholder Letters

 Annual Report to Shareholders

 Regulatory Reports

Value the Firm

 Review Market versus Book Valuation

 Historical technical trends on the value of the stock

 Calculate valuation based on Dividends, Earnings, Cash flows,

 Calculate and compare Intrinsic Value vs DCF

Identify Company Strategy

 What is the nature of products or services?

 How is the integration within value chain?

 What is their geographical diversification?

 What is their industry diversification?

 Is the firm targeting its products or services to its domestic market or integrating horizontally across many countries?

Essential elements in financial statement analysis

 Assess changes in the environments: are there new regulations, competitors, changes in the economy, new markets they have entered?

 Evaluate company capabilities and limitations: what the company’s primary capabilities?

 Assess of expectations of stakeholders

 Analyze company, competitors, industry, domestic economy and international economies

 Analyze the missions, goals and policies for the master strategy

 Determine critical environmental changes

Analyze Profitability and Risk

 Review or prepare common-size financial statements

 Review percentage change in financial statements year over year

 Review Financial Statement Ratios and identify variance anomalies and compare to industry and major competitors

 What are the Profitability Ratios: EBITDA, Product, EPS, ROCE, and they in growth or decline?

 What are the Risk Ratios: Current Ratio, Debt to Equity Ratio etc.

 Project Future Financial Statements

Identify Economic Characteristics and Competitive Dynamics in the Industry

 Prepare a value chain analysis

 Prepare an Economic Attributes Framework

 Conduct an Industry analysis

 Conduct a Competitor analysis

 Conduct a Supplier analysis

 Conduct a Customer analysis

 Determine if there are Substitute products that can impact sales

 Determine if there are technology changes or disruptors that can impact sales or costs – including those of the competitors

 Determine if societal factors have an impact on sales

 Review the firm's strengths/weaknesses relative to present/future industry conditions

 Create a goal/capability analysis: Are current goals, policies appropriate? Do goals, policies match resources? Does timing of goals/policies reflect ability of firm to change?

Alternative Analytical Frameworks

 Product life cycle – introduction, growth, maturity, decline stages with changing opportunities, threats

 Learning curve – costs decline with cumulative volume experience (first mover advantage)

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 Competitive analysis – industry, suppliers, customers, complementary products, etc.

 Value chain analysis – seek to add product characteristics valued by customers

 Niche opportunities – specialize in particular needs or interests of customer groups

 Cost leadership – low-cost advantages

 Product differentiation – develop products that achieve customer preference

 Product breadth – carryover of organizational capabilities

 Correlations with profitability – statistical studies of factors associated with profitability

 Market share – high market share associated with competitive superiority

 Product quality – customer allegiance and price differentials for higher quality

 Technological leader – keep at knowledge frontiers

 Resource-based view – capabilities are inimitable

 Relatedness matrix – unfamiliar markets and products involve greatest risk

 Focus matrix – narrow versus broad product families

 Growth/share matrix – aim for high market share in high growth markets

 Attractiveness matrix – aim to be strong in attractive industries