Someone emailed me this question:
“How do you evaluate a business's durability? What are the questions you are looking to answer? When you start to evaluate a new business in an industry you've not assessed previously, how do you evaluate durability?”
Let’s start by separating “moat” from “durability.” When I talk about the durability of a company’s competitive advantage, I call that a “moat.” That’s Warren Buffett (Trades, Portfolio)’s word, and it’s a good word so I use that. When I talk about a product’s durability I just use the term “durability.” The Portuguese company that makes cork (mostly for wine stoppers), Corticeira Amorim (COR, Financial), has a wide moat whether cork is a durable product. Its competitive position is strong, but there are substitutes for cork. You can stop a wine bottle with a screw cap. You can also produce a corklike product synthetically.
This distinction is important. When I read blog posts, talk to investors, etc., they seem really concerned about a product’s durability. They are too worried that the business in which they are investing may be a “buggy whip” industry. Realistically, you are going to lose much, much more money over your investment lifetime in companies that face competition than products that face extinction. Most people are too concerned with getting caught in a buggy whip industry and not concerned enough with getting caught in a business that is going to grow its sales but that is also going to become more competitive over time.
For example, I was recently talking to someone about the advertising and banking industries. We are talking U.S. banks here. I feel that big ad agencies and big banks are two of the most durable types of enterprises out there. Customer retention is very high. They have already adapted successfully to huge technological changes over the history of their industry. The ways they deliver the services they deliver have changed a lot more than their client rosters.
My newsletter co-writer, Quan Hoang, and I did an issue of "Singular Diligence" on Omnicom (OMC, Financial). One of the most important facts we provided there was a breakdown of a period where all advertising that wasn’t either online or TV went from a huge number to a really small number and – at the same time – the share of billings for major clients didn’t budge even an inch among the three biggest advertising agency holding companies. Basically, clients shifted from doing a lot of advertising on radio, in magazines, in newspapers, etc., to doing very little of that. And yet when they made this switch they didn’t make any changes to the creative agencies they used or the media buying networks that purchased the ad space on their behalf.
Ad agencies are durable because they have the flexibility to change with their clients without losing those clients. The same situation is true of banks. A bank is similar to an ad agency in that it has your primary financial contact. Everything else is much more at risk. People are more likely to “trial” different credit cards, PayPal (PYPL, Financial), etc., when it comes to the transactions they make, but the relationship that should be stickiest is your primary checking account.
I’ve talked with some people – even in the U.S. – who say they’ve switched the bank they use to get higher interest payments on their checking and savings accounts. If that becomes common, it’s a problem for the banking industry, but there are several reasons why this is unlikely. I already mentioned customer retention. That’s the most important one, but the key ones are new customers.
A big risk to the durability of any industry is the number of new customers in that industry. One of the big reasons ad agencies tend to be durable is that neither big demanders of ad space (big consumer brands) nor big suppliers of ad space (big media outlets like newspapers, TV networks, Google, Facebook [FB], etc.) appear out of nowhere. They start small and develop relationships early on and get bigger over time. Customers that are already doing something are less likely to try new things. Potential customers who aren’t yet used to doing anything are the bigger risk to durability.
Let’s return to the wine cork example. Wine drinkers are already drinking wine. Some young people who hadn’t been drinking wine before will age into the drinking cohort every year. It’s a small number. No more than about 2% of wine drinkers should be truly new to the concept each year. I might be off by 1% on that estimate, but I’m not off by much more than that. We can safely say that of those people buying wine this year, something like 95% to 98% of them were buyers of wine last year. They have habits. They already have an attitude about whether cork means a cheap wine or an expensive wine. They either like screw tops or they don’t. This is very important to the durability of wine corks. If 50% of wine drinkers were taking their first sip of the beverage this year, the situation would be totally different. It’s important to know that 95% to 98% (or more) of wine drinkers already have some habits when it comes to consumption.
That means the problem is obviously on the producer side. Turnover in wine drinkers is low. You’d need a societal shift where a bunch of them joined the bandwagon at once to cause wine stoppers to reach some sort of tipping point. Producers are potentially a different story. It may be the case that Old World (i.e., France) producers are committed to using cork, but there can be new and exciting developments in wine in the New World (i.e., New Zealand) countries that shake up the industry. I’ll use New Zealand as my example because it’s a small country that produces a lot of wine and therefore is basically an exporter that will have a real influence on wine buying habits around the world.
The cork industry ran into a problem where faulty corks were leading to wine that smelled bad. This ruined that bottle of wine. It was a huge disappointment for wine buyers who thought they had good bottles until they uncorked them and realized they were essentially ruined.
Now, how much does this matter if all wine is made by the French and the French have long-established habits of always using cork to stop the wine they produce? It’s no big deal. It’s temporary. The cork industry can realize its mistake. A few years later, it will have developed techniques that eliminate this risk of faulty corks. Everything will work out fine. What if this problem with faulty corks coincides with increasing production from new export markets like New Zealand? If Americans start buying wines from New Zealand that are screw tops and they are happy with those wines, that can change habits among American wine drinkers. You see the problem. You also see that the durability situation would have been much better for cork if there were zero new wine drinkers per year and zero new wine producers per year. The biggest risks to durability are the new wine drinkers and the new wine producers.
In Buffett’s terms this is simply “change.” He looks for the absence of change. That’s the easiest way to do this. There aren’t – in any one year – many new ad agencies being started or brands looking for agencies to run their campaigns. Nor are there – in any one year – many new banks being started or depositors looking for a bank. That’s what I like to see. If you notice, Buffett only just invested in Apple (AAPL, Financial). To me, the smartphone industry looks pretty “settled” now. It might be durable. It was hard to tell how durable it would be early on when a lot of people were buying their first smartphones.
That’s a problem you see in industries where you have a switch from one product to another, and the product is fairly durable. I remember looking at the mattress industry. Memory foam mattresses have really, really good economics. New kinds of mattresses are better than old kinds of mattresses. People don’t spend much on mattresses versus the comfort they get from them. You’ll hear people complain about mattresses that cost $4,000 or whatever – but you’re probably going to have that mattress for about eight years and sleep on it for way more than 300 nights per year so you’re talking about a purchase that’s going to cost you less than $2 a day. And you’re going to spend close to one-third of your day using this product. Mattresses are really cheap versus the comfort they provide.
The product economics of manufacturing and selling mattresses – versus furniture like case goods – is really excellent as well. There are economies of scale in the manufacture, distribution and advertising of these products. There is potentially a lot of brand awareness. It’s a really exciting business to look at, but there’s a problem. The adoption rate of better mattresses has been really high. Mattresses are durable – they’re like an iPhone that way, only more so – which means you have a situation like when Americans first started buying cars. Even if more people end up sleeping on memory foam this year than last year, we can’t know that sales of new memory foam mattresses won’t drop a lot. So, how durable is the year-to-year demand for new mattresses?
I don’t know. What that means is that you’re going to see cyclical-looking fluctuations in new mattress sales even if the adoption rate is much smoother. Deceleration in adoption will result in an actual sales drop that’s big. This is because the pace of first-time buyers of better mattresses drives a rate of new mattress purchases each year that is much higher than just the maintenance rate for these mattresses. There are other industries that are cyclical like lime. The demand for limestone and other lime products is durable long term, but I can’t predict how much unit demand for lime will be at a company like United States Lime & Minerals (USLM, Financial). This will show up statistically as a possible durability issue, but you can logically dismiss this as being mostly a cyclical issue.
There’s a similar issue related to price and substitute goods. Americans go to the supermarket each year and choose between meats like chicken, pork and beef. Price is a big part of this decision. If the price of chicken rises 20% while the price of beef falls 20%, people will buy more beef and less chicken. They won’t necessarily just eat more meat. They may eat the same amount of meat, but simply replace some of the chicken they eat with beef. If chicken and beef cost the same, they’d eat beef, but chicken always costs less. The spread between the price of these two meats influences how much they eat of each.
In this sense, there is no demand independent of price. That’s obvious, but it’s something people overlook. If oil is priced at $100 per barrel for 10 years, you will end that period with lower demand for oil than you would if oil had been priced at $20 a barrel for the last 10 years. There is a lot of room – given enough time – for consumers of oil-based products to adjust how much they use.
One advantage ad agencies have over other types of businesses is that they’re really the only economical way to get advertising of any kind done. There’s no substitute. The economics of managing things in house and buying your media spots directly aren’t good. I’ve tried to model some way where even a very big corporation can end up with equal or higher quality ads at lower prices if they do it any way other than using an agency, and, honestly, it can’t be done. You can’t create and buy ads as economically as an agency. It doesn’t matter what the medium is. It’s been true in every medium so far. Agencies that started in print moved to TV and now do a lot of digital haven’t seen this equation change.
For other kinds of businesses this isn’t true. The demand for dieting is durable, but the demand for Weight Watchers (WTW, Financial) may not be. That’s because Weight Watchers had advantages that were especially suited to offline groups. They expanded their brand into online, but apps can come along and different types of diets can come along and eat into the durability of this particular method of delivering a diet plan.
I recently sold Weight Watchers. I also sold Babcock & Wilcox Enterprises (BW, Financial). It has some problems that are similar. B&W does a variety of engineering jobs, but the new build of boilers and environmental equipment plus the upkeep of that equipment at coal power plants is a big part of its business. The problem here is how far it is from the end product. This is common to durability issues. The end product – the real “need” – is electricity.
Power is what people will always need. One step removed from the power consumer is the utility. Demand for electricity is perfectly durable. A utility is nearly perfectly durable (there may be ways to provide power without a centralized producer of power on a large scale although I’m unconvinced). Then you have the fuel the plants use. Babcock does work on plants that are designed to burn coal. This isn’t the whole company. It does other projects. I’m simplifying here. Without getting too technical, the way you burn coal and turn it into power is different from the way you use natural gas. What Babcock does – its area of expertise – is really geared toward big power plants that are either nuclear or coal powered. We’re really talking about boilers here, and the demand for big boilers is driven by providing power in certain ways. Two of those ways – the key two ways – are nuclear and coal.
If natural gas is cheap and coal is expensive, Babcock suffers. That’s why I mentioned the substituting of beef for chicken and vice versa. You can build a plant to run on natural gas instead of coal if coal is too expensive or natural gas gets cheap. In this case, there are also environmental concerns. Utilities had to spend more on cap-ex to meet environmental regulations if they wanted to burn a lot of coal in the future. Some plants didn’t see the economic logic in doing that so they just shut down.
This illustrates a key point. A business is generally more durable the closer it is to the end user of whatever it is this industry does. The chain of production here reaches from engineering work Babcock does on a new plant to the fueling of that plant with coal to the transmission of power produced using that coal to the end user’s home or office or factory. The transmission of power to the end user is the really durable business here. The building of certain kinds of equipment for certain kinds of power plants will always be less durable than the transmitting of power to the end user.
It’s best to own the hook-up to the end user. That’s really the only thing that makes cable companies durable at all. There is so much change in their industry. You’d think they’d be a “buggy whip” industry, but cable companies in the U.S. all have an effective monopoly over the wired hook-up to a house or business that can deliver a lot of data in different forms. Their durability is certainly challenged by phones that don’t rely on this hook-up, but cable is a lot closer to a utility in this situation than it is to something like Babcock.
Having a business that is less specialized, closer to the end user, etc., is always more durable than having a specialized business that is far removed from the end user. I often mention QLogic (QLGC, Financial) as an example of a case in which I found evaluating product durability to be impossibly hard. The company makes equipment that is used as part of organizing a storage area network for clients in a certain way.
The problem here is that the client’s need is data. That data may or may not have to be housed on site. And whatever is built on site may or may not have to be designed in such a way that the product QLogic makes will always be necessary. The demand for data is durable, but QLogic doesn’t make money directly off anyone’s demand for data. It is far removed from the end user. So, it’s not necessarily a very durable business.
This leads to a pretty boring and obvious conclusion. Consumer brands are durable businesses. Capital goods makers are less durable. You knew that already though. You knew that Coca-Cola (KO, Financial) is more durable than Ball (BLL, Financial) and you knew that Southern Co. (SO, Financial) is more durable than Babcock. You can see this in the “betas” of the stocks we are talking about. The market knows that Coca-Cola and Southern are durable and predictable because they are consumer brands and utilities that are close to a big base of customers who don’t often change their habits.
Meanwhile, investors know things can change for companies like Ball and Babcock who supply consumer brand companies and utilities and are thus further form the end user. Durability is highest where a business is close to the end user and the end user is a habitual user of the product. The classic example of this is cigarettes. Cigarettes have proven to be a surprisingly durable business even when everyone who smoked them knew the product was killing them. Well, cigarettes are sold directly to consumers who are habitual users of the product. Cigarettes are the perfect example of what durability looks like.
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