As investors, we are often quick to put on the CEO hat and contemplate business strategy of the companies in our portfolio. When it comes to a branded consumer business we may ask: Is the CEO right to extend the brand into a new product market? How will the latest acquisition affect the perception of the brand? What is the best strategy to fend off competition? Ultimately, the more informed we are about business strategy, the better investment decisions we can make. Or to borrow Warren Buffett’s famous words: “I am a better investor because I am a businessman and I am a better businessman because I am an investor.”
While it may seem easy to debate the merits of business strategy, the truth is that investors often struggle to ask the right questions or come to the right conclusions about which strategy a given business should be pursuing. In search for an analytical framework, we had the pleasure of recently learning from one of the thought leaders on wide-moat investing and management strategy: Pat Dorsey, President of Sanibel Captiva Investment Advisers.
In his hour-long session at Wide-Moat Investing Summit 2013 on July 9, Pat shared countless invaluable insights on wide-moat investing and, specifically, how business strategy can create and destroy competitive advantage. Below is an excerpt from the session transcript that highlights Pat’s thinking on the types of moats and the importance of fitting business strategy to the moat at hand.
Pat Dorsey on the Four Types of Moats
“The first is intangible assets, which is just what they sound like – brands, patents, approvals, licenses. Basically, some intangible thing that gives the company pricing power, enables it to price ahead above the competitive levels.
Switching costs, which is just what it sounds like. When the cost of switching to a new product or service outweighs the benefit of doing so and so you see customer inertia and stickiness, which usually again results in the company being able to raise prices at a fairly consistent level.
The network effect, which occurs when the value of a product or service increases with the number of users. Credit cards and financial exchanges being a couple of the prime examples here.
And then, finally, cost advantages, sort of business school 101. Being the low-cost producer is an advantage, but I think it’s very important to differentiate between a process-based advantage from, say, an EasyJet [London: EZJ] or a Southwest [LUV] or a Dell [DELL], which can be replicated over time, and cost advantages that stem from scale like a UPS [UPS] or a DHL, or a low-cost resource case, which tend to be more difficult to replicate.”
Pat Dorsey on Fitting Business Strategy to the Moat
“Because all competitive advantages are not created the same way, the corporate strategy that a CEO should use should differ depending on whether the company’s building a brand or creating cost advantages, whatever it might be doing. What’s right for a small company might not be right for a big one. What works in some industries might not work in another and this is why I think both as shareholders and managers need to be very wary of pretty much the entire management consulting industry because these management gurus, they always try to sell universal truths and you know what? There are no universal truths.
The strategy a company should pursue is unique to the business that company is in, to its size, to its competitive environment. It’s very easy as a management consultant to say, “Do these six things and your business will be better,” but the world just isn’t that simple. You can see why they do this – if you have a universal truth and the whole universe is your customer for a highly paid consulting gig – but it just doesn’t make any sense and strategies have to be appropriate to the industry context and the competitive context. So let’s talk about kind of the four different moats a little bit and sort of the strategies that make sense in each of those areas.”
Business strategy for moats driven by intangible assets:
“For intangible assets, I think it’s important for any business to remember that brands are valuable if they change consumer behavior by delivering a consistent or an aspirational experience. Consistency – every time I buy a Heinz ketchup it tastes the same – it lowers search costs. I don’t have to go all over looking for what I want and it encourages loyalty, repeat purchasing. Now aspiration increases the consumer’s willingness to pay and this is the true test of a brand – does it increase a customer’s willingness to pay?
So for consumer brands, the company should never give customers a reason to switch. The recent change of Heinz’s ketchup recipe was not a smart move in my opinion. We all go back to New Coke. You have the bestselling product on the planet almost, in terms of flavor water and you change the recipe – completely stupid. There’s an example, Schlitz that I’ll talk about in a little bit, which was the #1 beer in America for some time and they changed the recipe. I mean just absolutely stupid. With luxury brands, of course, you want to protect the image at all costs, create scarcity, do not overexpose. Luxury brands that push into new markets that try to grow too quickly risk overexposure and losing that aura of scarcity and exclusivity that enables them to have pricing power.
So the key thing here is remembering that aspirations differ. When we think about brands, the mark of a company that really understands how to manage its brand is understanding that the marketing message has to change to suit the cultural context and this is kind of a fun one.
So these are a couple different Jack Daniel’s ads. So the first one, this was in Russia in 2005. It says, “Happy Birthday, Mr. Jack,” I believe. If there are any Russian speakers and that’s wrong, you can correct me during the Q&A, but if you look at this, it’s very similar to the image of Jack Daniel’s in the U.S. – western, rough and tumble, down home – and that fits the Russian cultural context.
Then you look at a Jack Daniel’s ad that ran at the exact same time, exact same time, in China and you can see that you’re in kind of an urban area, it’s a very cool, sophisticated bar and as far as my Chinese-speaking friends have been able to tell me, that quote at the bottom you see basically says, “Confidence does not come from within, confidence is in the eyes of the beholder.” In other words, drink Jack Daniel’s and you will be really cool. That speaks to a rapidly urbanized society where people don’t want to go back to the village. You wouldn’t pitch Jack Daniel’s in China as kind of a homespun, back-to-the roots brand. You want to pitch it as a luxury brand, as something that says, “I’ve arrived.”
So you can see, same product. It’s a luxury good in both markets, but sold very differently and I think that’s the mark of a really, really smart brand management strategy.”
Business strategy for moats driven by switching costs:
“With switching costs, you want to look for businesses that integrate with customer business processes. The upfront cost of implementation, I’ve found, tend to yield big payback from renewals. So businesses that sell a solution that includes an ongoing service relationship, think of elevators, jet engines, aircraft parts where you might break even on the OEM sale, but the aftermarket can carry 60-70% EBITDA margins.
Another interesting thing I found with this area is that I often find that customer stickiness is higher with products or services that address pain points instead of revenue opportunities. So Ecolab [ECL] is a business in the U.S. that basically started out doing sanitation solutions for restaurants, for example. So if you run a restaurant, no one is going to come to your restaurant because it’s cleaner than everywhere else. They expect a minimal level of cleanliness and food safety and after that, it’s the food that matters. So food safety and good food-handling techniques, this is not a revenue opportunity for a restaurant owner. It’s a pain point, it’s something you’ve got to do and so Ecolab says, “We’ll solve that for you. We’ll train your staff. We’ll put the right hand-washing dispensers in the right spots and whatnot.”
Stericycle [SRCL] disposes off medical wastes, similar story. AJ Gallagher [AJG] is an insurance broker. If you’re a small business, insurance is a pain point, it’s not a revenue opportunity. You have to have insurance, but it’s something you want to sort of make sure you have the right stuff for the lowest cost and move on and so I find customer stickiness in these kinds of businesses that address pain points versus revenue opportunities. Then also companies that provide a product or service with – what I call – a high benefit/cost ratio. So think about accountants. There’s a company in the U.S. called Robert Half [RHI] that does very well selling temporary accountants.
So let’s say you need to hire a couple of spare accountants to help close your books at the end of your fiscal year. Now you can go with a really cheap solution and maybe the accountant does a fine job or maybe he screws something up and you get sued or you get an audit from the tax people or you can pay a little bit more for someone from Robert Half, get someone you know has good quality and is less likely to screw up. This is a case where there’s a very high benefit to paying a little bit more for the better product – in this case a person. So Robert Half is able to generally enjoy better returns on capital than kind of more commoditized temporary help firms.”
Business strategy for moats driven by the network effect:
“With the network effect, I think this is one of the few areas where the first-mover advantage is worthwhile. Otherwise, it’s often code for we get into this business first and we can screw up enough, so people can learn from us and crush us. So you want to look for businesses that are scaling quickly. eBay [EBAY] is a classic example. CoStar [CSGP], which is a wonderful business that has a commercial real estate database, so kind of the Bloomberg of commercial real estate.
Positioning yourself between very fragmented groups of suppliers and users, so Edenred [Paris: EDEN] with its restaurant ticket business, Fastenal [FAST] with its MRO business, but the key here is you want to watch for large groups of users who can establish critical mass. So that’s why you want fragmented groups of suppliers and users. If your customers are very concentrated, they can get together and basically create critical mass with a competing network, which is what BATS did to Nasdaq [NDAQ]. BATS (Better Automated Trading Systems) basically was a startup funded some years ago and really took a lot of share from Nasdaq and other exchanges.”
Business strategy for moats driven by cost advantages:
“In terms of cost advantages, you want to look for companies that if they have a process-based cost advantage, they just found a way to do something smarter. This is the Dell or Southwest or EasyJet example. They need to know this because that advantage is temporary and somebody will copy it. So complacent managers, they really, really get into trouble there very quickly. If its scale is the source of the cost advantage, you want to look for businesses that win through attrition. They fight the war, not the battle. UPS and FedEx [FDX], who drove out DHL in the U.S. ground delivery market, not because DHL is a poor competitor – they run a wonderful network in Europe – but they just couldn’t scale in the U.S. What they did, UPS and FedEx, they didn’t try to go after them and aggressively price. They just realized that over time, DHL couldn’t win. So they won through attrition. It’s exactly what you want to see from a company with a scale advantage.
In terms of a cost advantage coming from dominating a niche, you can basically grow via expansion into complimentary niches, you can use your scale to enter a lot of niches or – and these are some of the best businesses – you be comfortable with not growing – See’s Candies, Genuine Parts [GPC]. Not growing is okay and managers who realize that sometimes are better than the ones who want to be masters of their own universe.”