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Sustainable Competitive Advantages

July 08, 2010 | About:
Most long-term business investors look for high-quality businesses. But what exactly makes a business of high quality? Unfortunately, many investors fail to ask themselves this very simple question. High quality businesses are usually a result of a sustainable competitive advantage. Let's take a look at a few key competitive advantages. Going through this exercise helps focus investors' attention on the businesses that are most likely to offer extraordinary opportunities.

Low-Cost Provider

People and organizations purchase goods and services for several reasons, primarily for need, convenience, improvement or pleasure. Those purchased for improvement or pleasure compete not on price, but on value added. However, those purchased for need or convenience typically compete on price. The lowest-cost provider has an immediate advantage over higher-cost competition. This allows the low-cost provider to enjoy higher profit margins and allows it to drop prices and profitably take market share from competitors.

Distribution Infrastructure

All goods and services are sold and distributed through some identifiable infrastructure. The companies that control these distribution networks can act as toll booths and collect fees whenever goods and services pass through. While pricing in monopolistic infrastructures of basic living needs (water, sewage and electricity) is heavily regulated, pricing is moderately regulated when there are few alternatives (transportation and communications), and lightly regulated when there are many alternatives. The best returns on capital are likely to be found in distribution networks established by demand rather than a lack of alternatives.

Patents/Technology

The profitability of inventions and innovation depends on the ability to prevent others from copying ideas. This is most clearly evident in health care and technology industries, where many end products are completely dependent upon patent protection. While businesses that depend on patents and technology can have relatively short-lived success, businesses that use patents and technology to add value can enjoy long cycles of success.

Monopoly/Oligopoly

Some businesses are monopolistic or oligopolistic. Neither of these, in and of themselves, inherently leads to superior results. It also depends on the nature of the product or service, or the level of regulation. An example is the aforementioned regulated utilities businesses. Monopolies and oligopolies can form due to special geographic characteristics that limit availability of goods or services. Again, the best monopolies and oligopolies are those formed by demand because they are more natural, rather than forced, and are less likely to be regulated.

Intellectual Capital

Entire businesses can be built from a collection of data or from someone's ability to think. While information is becoming more readily available for collection in the information age, intellectual capital (people's brains) is more difficult to copy. Because data can be reproduced and ideas can be copied, information and intellectual capital are most valuable when they can be controlled or when they are time sensitive. This is evident in the ability of highly skilled managers to collect information, evaluate it, and become the first mover with a new competitive strategy or business model. In select businesses, such as investing, the same intellectual advantage can be applied over and over.

Captive Audience

A captive audience is extremely valuable because the cost of gaining someone's attention is very high and the cost of gaining their business is even higher. Not only is a captive audience expensive to gather, but it is extremely valuable once in place. Because so much time, money and energy are spent trying to engage potential customers, businesses with captive audiences enjoy a certain type of leverage. These businesses can instead focus their attention on business improvement and potentially cross-sell new products to their existing captive audiences. A captive audience can be built through successful branding or through a special physical location or relationship.

Sustainable competitive advantages don't necessarily exist in a vacuum. Some businesses enjoy more than one of these key advantages. For example, Coca-Cola (KO) controls a majority of its distribution infrastructure, operates in a soft drink oligopoly, and has a captive audience. Google (GOOG) has access to key search technology, operates in a search oligopoly (nearly a demand monopoly), attracts and retains top intellectual capital with its unique corporate culture, and has a captive audience as it offers one of the most frequently used services in the world.

Sustainable competitive advantages can also become more deeply entrenched when combined with other favorable characteristics such as high switching costs, convenience, key relationships, scale, and habit formation through frequently recurring consumption and purchase decisions.

This is just a brief overview, but it is often helpful to revisit the most fundamental elements of investing, especially in the face of uncertain times.

Disclosure: No positions.

By

Nathan Kawaguchi

IgnoreTheMarket.com

About the author:

Nathan Kawaguchi
Nathan Kawaguchi is a Research Analyst for IgnoreTheMarket.com. IgnoreTheMarket.com provides independent, value-based stock and mutual fund research, a blog, and acts as a hub for value investing information and research. Nathan Kawaguchi is a former stock broker and has over 10 years of experience analyzing securities.

Visit Nathan Kawaguchi's Website


Rating: 4.4/5 (35 votes)

Comments

DocMoney
DocMoney - 3 years ago
Excellent summary. 5 stars. Would like some examples of companies with moats in each category.
IgnoreTheMarket
IgnoreTheMarket - 3 years ago
DocMoney, thank you for your high regards. It's funny... actually, my first draft of that article had lots of specific names, but I didn't want it to seem like I was packing the article with tickers in order to get picked up more easily in search engines. I'd be happy to provide some examples here:

Low-Cost Providers--Wal-Mart, Costco, Target, AutoZone, Staples, Amazon.com, Home Depot, Lowe's, TD Ameritrade, Charles Schwab and Progressive. There are a lot of commodity-type businesses that appear to be dominated by low-cost providers, but I don't do enough work there to assure accurate names.

Distribution/Infrastructure--Wal-Mart, AutoZone, Advance Auto Parts, Genuine Parts, O'Reilly Automotive, Coca-Cola, Pepsico, Procter & Gamble, Colgate-Palmolive, Kimberly-Clark, Viacom, News Corp, Disney, Comcast, Time Warner Cable, Liberty Global, AT&T, Verizon, Vodafone, Sysco, EcoLab, Stericycle, Waste Management, Republic Services, Visa, Mastercard, American Express, FedEx, UPS, IBM, Omnicom Group, Norfolk Southern, CSX, Patterson Companies, Henry Schein, VCA Antech, MWI Vet Supply, Staples, CVS Caremark, Walgreen, Lab Corp of America, Quest Diagnostics, Johnson & Johnson, American Tower, Crown Castle, Iron Mountain and a lot of utility and transportation companies on which I am no expert.

Patents/Technology--Google, Microsoft, Oracle, IBM, Cisco, Intel, Apple, Abbott Labs, Alcon, Boston Scientific, Johnson & Johnson, Medtronic, St. Jude Medical, Stryker, Zimmer Holdings and Dolby Labs. I do not do a lot of work in this area unless there is a clear edge and/or a broadly diversified product portfolio.

Monopoly/Oligopoly--Google, Microsoft, Visa, Mastercard, Coca-Cola, Pepsico, Procter & Gamble, Colgate-Palmolive, Waste Management, Republic Services, Stericycle, AT&T, Verizon, Comcast, Time Warner Cable, Liberty Global, DirecTV, DISH Networks, Moody's, McGraw-Hill, Visa, Mastercard, American Express, Home Depot, Lowe's, and of course the countless utilities.

Intellectual Capital--Google, Walt Disney, News Corp, Viacom, Berkshire Hathaway, Fairfax Financial, Loews (not Lowe's), Leucadia, Markel, Brookfield Asset Management, White Mountains Insurance, Alleghany, Dun & Bradstreet, Dolby Labs, Thomson Reuters and Amazon.com.

Captive Audience--Most of the aforementioned names have a captive audience. There are other media names such as Lamar Advertising that have sustainably captive audiences. But with the recent audience fragmentation of media, it's hard to say which media have truly sustainable competitive advantages.

Hope this helps.
batbeer2
Batbeer2 premium member - 3 years ago
Low-Cost Provider.... Monopoly/Oligopoly... Captive Audience

Are these advantages or are they the result of an advantage ?
IgnoreTheMarket
IgnoreTheMarket - 3 years ago
Batbeer2, your presumably rhetorical question is a good one. Unfortunately, in many examples we run into circular arguments because there are not usually isolated cause and effect situations in complex adaptive systems such as economies. For example, Microsoft has a monopoly on two very profitable pieces of software in Windows and Office. One could argue that these monopolies are a result of Bill Gates' early vision of the future PC market (intellectual capital). One could also argue that fulfillment of his vision was dependent upon having control of key technologies (also intellectual capital). One could further argue that early access to those technologies allowed Microsoft to gain an early mover advantage in a market of extraordinary opportunities for growth. And because billions of people boot up their PCs and see the Windows OS each day, they clearly have a captive audience.

Your point is well taken and to which I have no opposition, but it is important to point out that competitive advantages are often a product of a confluence of various factors as in the example of Microsoft. As a side note, Microsoft's competitive advantages are not as strong as they were a decade ago. It just happened to be the first company that popped into my head.

As always, thank you for your intelligent comments. Challenging questions and oppositions are welcome.
batbeer2
Batbeer2 premium member - 3 years ago
Challenging questions and oppositions are welcome.

Indeed ! and as far as I'm concerned it works both ways. The question was less rhetorical than you might think ; I appreciate your reaction.

Microsoft is a good example. It has huge advantages, but what makes them durable ? IMO what was true for IBM is now true for MS. Nobody ever got fired for implementing a MS solution. Many corporate decisions are made that way.

Also, they have a huge support network that others lack. The same goes for say... Oracle.

You list things you need to look for in a quality business, I know I do. However, I try to understand the source. PMD for examle has patents.... nice. JNJ on the other hand seems to be able to generate new patented technology time and time again....that is sustainabe.
cm1750
Cm1750 premium member - 3 years ago
IgnoreTheMarket,

Great list of companies. I would like to add PM (also MO and BTI) as it fits the oligopoly, distribution and captive audience (addictive) criterion.

Pricing power is a related category that allows companies to improve ROIC, margins and battle the potential impact of inflation. Tobacco companies have proven their ability to raise prices over the years.
DocMoney
DocMoney - 3 years ago
What a great discussion! I would like to bring into focus the issue of sustainability of a competitive advantage. Like Batbeer said, intellectual property is an advantage, but ability to continually generate new intellectual property is a sustainable advantage.

Now, let's take a look at what we've discussed and see which competitive advantages are most sustainable.

Low cost provider? If it comes from streamlining/efficiency, it may not be sustainable since a competitor may achieve similar results eventually. A competitor may also choose to run at a loss for a while, if it has another advantage (more cash on hand to afford running at a loss in order to breach the low-cost moat). Within Nathan's list, there are competitors: Walmart-Costco-target, for instance.



Distribution/infrastructure
- May get built, over time, by competitors. This is why there is, again, competition within Nathan's list - Advance Auto Parts - Genuine Parts - O'Reilly Automotive, Coca-Cola - Pepsico...

Patents/Technology - Plenty of competition there too. Take drug companies - How many competing drugs from a similar class are there? For example, there are numerous anti-heartburn drugs (proton pump inhibitors), all technically different and each protected by patent but with the same mechanism of action!

I am running out of time to write this, but I think the subject of sustainability and durability could be examined in much greater detail.
IgnoreTheMarket
IgnoreTheMarket - 3 years ago
Wow, thank you all for the excellent input. I agree with each comment. The topic of sustainable competitive advantages is at the very heart of long-term investing. Personally, I practice and advocate focus investing, which requires great understanding about the strength and sustainability of competitive advantages.

A good way to address the differences is to require larger or smaller discounts to fair value, depending on the strength AND sustainability of each company's mix of competitive advantages.

Consumer electronics companies, including Apple, give me trouble. The product cycles are so short (3-7 years) and the technologies move so fast, it's just difficult to say with a lot confidence that any one company will be able to continue to profitably innovate. The mobile phone market is a great example. Nokia, Motorola and RIM were each considered by many to have sustainable competitive advantages at one time. While I am impressed with Apple's understanding of the consumer, it would not shock me one bit to be talking about another great mobile phone company 5 to 7 years from now.

On the other hand, one can be much more confident that Wal-Mart's competitive advantages will sustain its business for at least another ten years, and likely many more.

While I don't let DCF analysis control my investment decisions, it is extremely helpful to look at the math in understanding the nature of long-term returns. For many typical investments, about half of the present value comes from cash flows beyond ten years. This means that a competitive advantage must be sustainable for at least twenty years (for most typical FCF investments).

This is a fantastic topic and I could easily go on, but I think you've read enough of my blabber for now...
halis
Halis - 3 years ago
As far as the advantage of low-cost provider goes, I have a few thoughts. One thing that has always confused me, is how Buffett talks about Geico's competitive advantage of being the low-cost provider and how it's something that cannot be replicated. I don't think that is the case today, if even in the past. Not selling with agents, selling direct, while a novel concept back in the 40's, is nothing new today. I think insurance companies can sell direct, via the internet, easier than ever before.

There are new insurance companies that have copied his model. There are captive insurance companies, that have started or purchased subsidiaries that only sell direct, mostly through the internet. Progressive sells via agent or direct. I think it will be interesting to see if a major insurance carrier at some point tries to eliminate its agency network. Perhaps Buffett is right in the sense that, Geico has such a head start on the direct model, that no one will ever be able to catch them.

When you look at a low-cost provider like Wal-Mart, to me that seems like a much tougher nut to crack for competitors. Their technology in logistics alone (which is more advanced than the US government's) makes them very tough to attack. Also, with their purchasing power, absolutely no one can get volume discounts like they can.

Wal-Mart earns nearly the same margins as Target, but with only 1/3 of the leverage. How do you even begin to assail that position?
IgnoreTheMarket
IgnoreTheMarket - 3 years ago
Halis, about the direct selling of insurance... GEICO's market position is similar to that of Charles Schwab in brokerage. When the market is good, you see a few new online brokers pop up here and there. However, just because an advantage can be duplicated, doesn't mean it will be done so successfully. A great example is BJ's Wholesale. They operate the same business model as Costco, but they just can't get it done with the same effectiveness.

Unless a company has a very unique and large advantage, it takes a long time and a lot of money to take market share from incumbents. Scale presents a very difficult pricing hurdle for newcomers because the pricing advantage would need to be substantial. Consumers of financial products have to see a meaningful difference to go through the hassle of moving accounts and taking the risk on an unestablished newcomer, especially because confidence and familiarity are so important when dealing with very sensitive financial matters.

Wal-Mart is clearly more efficient than Target and benefits from greater negotiating power. However, the leverage difference is not quite as big, depending on how one looks at it. Target owns a majority of its stores, so once its leverage is paid, it's gone. Wal-Mart has far more operating leases, which get renewed (off-balance sheet). Also, Target's nonrecourse credit card receivables debt is on its balance sheet too. Both company's are in good financial shape and one could actually argue that Target is the stronger of the two.

Thank you for more great input. This is by far the most productive thread on any of my articles so far.
batbeer2
Batbeer2 premium member - 3 years ago
Bruce Greenwald has something to say on the matter.

http://www4.gsb.columbia.edu/ideasatwork/feature/70215/Understanding+competitive+advantage

Can you talk about why competitive advantages are easier to sustain in localized markets?

The obvious thing is that sustainable competitive advantages have to be competitive advantages that apply not just to existing customers, because they die off sooner or later...... Proprietary technologies go away too, because technologies die. And if they don’t die, they just become common property, and so nobody has an advantage after the technology diffuses.....

What you need is something that’s an advantage in the market for new customers who are in the market for new technologies. That is what economies of scale do. When Intel goes after the next generation chip, because it’s got some degree of customer captivity — which is crucial to scale advantages — Intel can expect, if it’s successful, to get 10 times as many customers as AMD. That means Intel can spend 10 times as much on developing and marketing the new chip. That’s the advantage of scale. So who’s going to win that race every time? Intel.

Similarly, in software Microsoft is the company that’s most likely to add new features, so people are going to continue to learn how to use its programs. Microsoft’s costs, because it’s spreading them over 100 million customers and everybody else is spreading their costs over maybe 10 million, are massively lower than everybody else’s. So again, in the pursuit of new technology, Microsoft does better.

....

Economies of scale are really the key to truly sustainable competitive advantages. It’s easier to be the dominant competitor in a market where you’ve got 60 percent of the market and there’s not enough left for everybody else.....

IgnoreTheMarket
IgnoreTheMarket - 3 years ago
Batbeer2, excellent, excellent, excellent!!! You nailed it. I completely agree about technology and its sustainability, or lack thereof in some cases. The difference, I believe, is whether the company is dependent upon new technologies, or if the company benefits from new technologies.

Tech companies like Intel and IBM enjoy scale and extensive distribution capabilities. These qualities turn Intel and IBM from being dependent on new technologies to benefiting from them. Their size gives them huge R&D budget advantages over the competition. While far from certain, they are more likely to come up with new technologies. And when other companies develop them first, their size gives them the financial power to acquire these new technologies and simply plug them into the existing distribution channels. In fact, selling out can be viewed as a win-win and is often an exit strategy for smaller controlled companies. That is a huge advantage that comes with scale and distribution.

I don't do too much investing in traditional tech companies because of your next great point about advantages in markets for new customers. This is why I like consumer brands so much. Parents can pass that brand value right along to their children starting at a very young age.

We see this in localized markets as well. Each local market has its own set of unique characteristics for which incumbents have established competitive advantages. In order to penetrate a market, a new entrant must have a clearly obvious advantage or it must be able to bypass the existing nuances of local competition that have been finely tuned over generations.

The best example is restaurants. It is so difficult to grow a chain of Mexican, Italian or Chinese food restaurants because each local market has its own established players that are usually family-owned restaurants that give local residents great pride (everyone thinks they have the best such-and-such restaurant in their town).

And I absolutely agree that scale is key, especially where there are high distribution costs. That is probably the number one recurring theme when I think about great companies.

Thanks again for your excellent input.
batbeer2
Batbeer2 premium member - 3 years ago
Ehm.....

That's not me but Greenwald talking. As some on this forum probably know, I'm not a big Greenwald fan. Having said that, he explains this in a way I can understand; glad you appreciate the link though.

For me, I find it hard to assign a value to a moat. I like to see them, but I assign no value to them. Instead, I like to buy below what I perceive to be liquidation value. In such cases, you do not need to analyse the moat. That too is explained well by Greenwald.

JacobW recently posted one of Greenwalds lectures in which he talks about moats. The video is worth watching; he mentions more examples.

http://www.gurufocus.com/forum/read.php?1,97805,97962#msg-97962
IgnoreTheMarket
IgnoreTheMarket - 3 years ago
Yeah, I think I've seen the Greenwald lecture before. I have seen most video/lectures that CBS puts out.

Investing with a margin of safety, the way I see it, is buying at either a discount to net asset value or discounted future free cash flows. While I have bought things based on assets, I prefer to find cash flow compounding machines. Either way, we're faced with risk... the risk that the assets don't retain their liquidation value or the risk that future cash flows don't materialize. It is very analogous to a comparison of collateralized debt and unsecured debt. The risk is in the quality of the assets or the ability to generate future free cash flow.

I am not the biggest fan of Greenwald either, but he has plenty of valuable lessons that are worth listening to and some of his ideas have sparked some important insights for me over the years--particularly how I think about local competition in terms of national and multi-national companies.

Similarly, I don't assign a value to a moat. However, the quality of the moat is certainly taken it into consideration when I'm deciding how big of a discount to fair value that I will require for any given investment. This is especially important for investments based on future free cash flows. For most FCF investments, about half of the present value comes from cash flows beyond ten years.
Sivaram
Sivaram - 3 years ago
HALIS: "As far as the advantage of low-cost provider goes, I have a few thoughts. One thing that has always confused me, is how Buffett talks about Geico's competitive advantage of being the low-cost provider and how it's something that cannot be replicated."

What Buffett said may not be true anymore. People, especially value investors, keep treating moats as something that can be retained forever. The reality is anything but.

As recently as 10 years ago, newspaper companies had a very powerful castle with a huge moat. Right now, the castle is crumbling and everyone can just walk right into it, not to mention the invading armies with superior means.

I don't know much about insurance companies like Geico (haven't given it much thought) but it wouldn't surprise me if it has a weak competitive advantage now. Because it's large (2nd largest auto insurer in the US I believe), it still has economies of scale and other competitive advantages that will keep costs down. But the emergence of the Internet, as you point out, has likely eroded its moat significantly.

Going forward--this is pure speculation on my part--I believe the next established moats to fall will be those of the branded consumer packaged goods companies and similar ones. For instance, I have my doubts that Coca-Cola will be as dominant in 10 years as now. I wouldn't bet on it declining but I wouldn't bet on it earning something like 20% ROE (with low leverage) past 10 years either.
softdude2000
Softdude2000 - 3 years ago
Sivaram, Why do you think KO orh other branded goods moat will weaken?
halis
Halis - 3 years ago
Sivaram,

Thank you for your thoughts. The idea of the moat failing for consumer goods companies is something that pops into my head every now and then. I think it's impossible to know, but possible nonetheless.

These brands have reached saturation point, for the most part, in the U.S. To continue meaningful growth, they will have to make huge foreign investments in emerging markets. Now I feel they have a good chance in these markets. Many big companies have already succeeded in foreign markets and they have learned things in the process. They have learned what they need to tweak to make their goods marketable to different cultures. And they have plenty of money to back the products up. But the downside is competing with everyone else in that country and the uncertainty of foreign governments.

Consumer goods companies also have to worry about increasing competition here at home. The market continues to become more and more fragmented. This drives up marketing costs as each sliver of the market becomes more and more specialized. So you have new products all the time, positioned all over the place. You have competition from private label goods, which are essentially the same, and you see this in warehouse clubs very frequently.

I am almost inclined to say that the companies that decide to create new brand names, as opposed to extending an existing line, will be the ones that come out on top with more market share. But that points to the continued success of the existing consumer goods companies. But I think it is very hard to know.
AlbertaSunwapta
AlbertaSunwapta - 3 years ago
I see some of the competitive advantage of companies like Microsoft stemming simply from customers hatred of change. Customer understanding and familiarity create comfort and loyalty and thus a wide moat. eg. once someone learns English they aren't likely to learn Spanish, Chinese, etc.

A better example might be the QWERTY keyboard. Poor as it is, I imagine QWERTY will even survive the adoption of touch screens. Yet outside the classroom and industry having adopted it as a default standard, it's still a personal choice with supposedly superior keyboards readily available and now touch screen alternatives just a click or two away. Basically, once users learned the "language" Windows, Word, Excel, etc., (even when it was forced upon them by IT departments) they were highly unlikely to switch even when superior functionality was available because it would have required more cost and effort to learn and integrate the new products.
AlbertaSunwapta
AlbertaSunwapta - 3 years ago
I see some of the competitive advantage of companies like Microsoft stemming simply from customers hatred of change. Customer understanding and familiarity create comfort and loyalty and thus a wide moat. eg. once someone learns English they aren't likely to learn Spanish, Chinese, etc.

A better example might be the QWERTY keyboard. Poor as it is, I imagine QWERTY will even survive the adoption of touch screens. Yet outside the classroom and industry having adopted it as a default standard, it's still a personal choice with supposedly superior keyboards readily available and now touch screen alternatives just a click or two away. Basically, once users learned the "language" Windows, Word, Excel, etc., (even when it was forced upon them by IT departments) they were highly unlikely to switch even when superior functionality was available because it would have required more cost and effort to learn and integrate the new products.

Simple put - 'switching costs', comfort, 'learning effort' or whatever you want to brand it as, creates a powerful moat.
Sivaram
Sivaram - 3 years ago


SOFTDUDE2000: "Sivaram, Why do you think KO orh other branded goods moat will weaken?"

This is just macro speculation on my part and value investors should ignore it. Having said that...

I don't know about Coca-Cola specifically but I'm bearish on companies like that, including companies like Kraft, P&G, Kellogg, etc.

My view is driven primarily by the belief that consumers, not just in USA but throughout the developed world, won't be able to afford premium products going forward. For the last 40 or 50 years, these companies have done remarkably well. The reason, in my opinion, is due to the growing consumer class in the developed world. For instance, workers in America saw wages rise significantly between 1940 and 1990. I think a lot of the income supported the branded products, which cost a lot more relative to competitive products.

My expectation is for the developed world to see lower growth rates over the next 10 years (or maybe even longer.) The debt build-up is so large that it is going to suck out some growth for a long time. I have a feeling thta consumers just won't be able to afford these premium products even if they wanted to.

On top of all that, thinking strictly from a contrarian point of view, how long can these companies generate so much profit for so long? The companies in question earn around 20% ROE and have done so for decades. They have lower volatility than many other similar-sized companies. They also tend to have low debt levels. I mean, just look at their total return over the last 30 or 40 years (there is survivorship bias but even if you look at the industry it looks too good.) It's almost as if you have found a perpetual money-making machine.

My contrarian impulses suggest that these companies are going to mean-revert. I have a bad feeling that many of them are going to turn into value traps (similar to Pfizer.) Value investors love these companies but they loved financials before the latest bust too.

So, that's my feeling. Yes, it isn't much of a proof and is based more on my speculation than anything.
IgnoreTheMarket
IgnoreTheMarket - 3 years ago
Sustainability of competitive advantages in consumer products... this is a fantastic topic because these leading consumer brands have almost every single desirable quality you could want in a business.

While I share the macro concerns for the developed world, opportunities in emerging markets should offset much of this concern. There are a LOT more people in the developing world than the developed. And most of them are currently below what we would consider middle class. If the past is any prelude, the developing world should see booming growth its middle class over the next decade or two. These new middle class consumers will likely follow a familiar consumption pattern.

Because of certain physiological and psychological factors, most consumers move up and down a consumption scale that corresponds with their standard of living. From lowest to highest, most consumers buy products based on: Sustenance => Convenience => Pleasure & Diversity => Health & Well-being. Not all consumers pass neatly through each of these stages for every product, but most do. As emerging market consumers shift from sustenance and convenience to pleasure and diversity, they will enter the target income of these global consumer brands.

There is no certainty that these leading American brands will be able to penetrate and dominate these emerging markets because of regulatory, cultural and other hurdles. However, scale and distribution provide a number of avenues for favorable outcomes. Plus, many of these brands are already finding much success in emerging markets.

Coca-Cola is particularly interesting because its moat is more likely to hold up in the future due to a few unique factors. First, Coca-Cola provides a very essential daily living need -- hydration (8-9 8 oz servings of fluids per day). And because it is something we ingest, we are more likely to be sensitive to brands than say, laundry detergent. Also, because fluids satisfy a bodily need, our brains build an association of hydration with specific flavors and brands of beverages. This is very similar to smokers preferring the same brand of cigarettes (except is satisfying an addiction, rather than a need of sustenance). Of course, caffeine and sugar provides a similar hook in many of Coca-Cola's products. With food, however, consumers are quick to seek diversity because we get tired of the same food quickly. Coca-Cola also has a dominant position in South America, where the climate generally favors cold beverages.

There are so many other factors that could work out quite favorably for the leading consumer brands, but I think this comment is long enough already. While there are risks in every investment, I still believe it is appropriate to view these leading consumer names as super-high-quality, inflation-adjusted corporate bonds.
halis
Halis - 3 years ago
While we are on the subject of competitive advantage and Coca-Cola, I thought this might be relevant. I read somewhere, either a magazine or a book, that there are 3 things in every single village on earth. 1) Coca-Cola 2) Cigarettes 3) Cell Phones
rgosalia
Rgosalia - 3 years ago
I was on a vacation last week to Maui HI, and visited this tiny village that was about 3 hours away from the popular tourist destinations via an unpaved road. When we got to the village, my wife was looking for coffee. It was past 5 pm, and all the shops in the village were closed. But, we found Coca Cola.

What makes KO unique is not the product itself, but their ability to develop an entrenched distribution system, which is extremely difficult (and uneconomical for a new entrant) to replace. Maybe, 20 years from now, people are health conscious and don't want to drink the beverages of today. But, I feel quite confident that whatever the beverage of the day then, Coke and Pepsi will own these beverages. Just look at what both have been doing with the new popular beverages - sports drinks, energy drinks, vitamin water etc.

This isn't just true in developed nations. I was raised in India and we did not have Coke and Pepsi when I was growing up. We had a local soda company called ThumsUp. When Coke entered the market, it bought over ThumsUp, and strengthened its marketing and distribution engine even further. Today, both Coca-Cola and Pepsi are deeply entrenched today - you can easily find either of two companies products in any small town or village and its over all the media (just like the developed countries). They continue to do what they do best - take mind share through media outlets. People recognize Coca-Cola as the symbol of happiness and Pepsi as the choice of the new generation.

Combine this with what one of the previous contributor said, the rise of the middle class in the emerging countries is only going to make the demand for Coca-Cola and Pepsi products more inelastic (as the proportion of income spent on these products starts becoming smaller).

Both Coca-Cola and Pepsi are at the lowest valuation today when you look at the last decade. In my opinion, both are great ways to have a stake in the emerging markets for the next 20 years at these attractive multiples. It seems extremely unlikely that their moat is going to erode over the next 20 years, but even if it does it is probably going to be very slow and at these prices there is a very reasonable margin of safety.

Disclosure: The author has a long position in KO and PEP.

Sivaram
Sivaram - 3 years ago


Good points IgnoreTheMarket... I hope you don't mind me debating a few of your points...

IGNORETHEMARKET: "While I share the macro concerns for the developed world, opportunities in emerging markets should offset much of this concern."

I'm not so confident about that. The market shares your view and most would agree with your thesis but it remains to be seen.

If you look at many multinationals (not sure about Coca-Cola) you'll find that the vast majority of their sales, and most importantly profits, come from the developed world. It depends on the company but I would say a typical company depends on USA for around 30%, Europe for another 30%, and Japan for maybe 10%. Even companies with very fast emerging market growth often have a very small market (relative to their total) in those countries.

On top of that, you'll find that the profits (in absolute $ and not in terms of margins) in the developed world is far higher than the developing and undeveloped world. Someone knowledgeable about Coca-Cola correct me but I would guess that Coca-Cola earns US$1 per bottle (revenue) in the developed world whreas it might earn US$0.25 in developing countries. Gross profit might be around $0.50 for the developed world and $0.20 for the emerging world. Even if the profit margins were higher in emerging markets, you would need 2x to 4x the sales just to match the developed world.

Now, some would argue that the emerging markets are far larger. The untapped demand is very large. I agree. However, extrapolating that to what happened in USA (in the 1900's) may turn out to be risky. The per capita income in even the fastest growing sizeable emerging markets, like China, is a fraction of the developed world. It will take 100 years to reach anywhere near the American income.

I always argue against oil bulls assuming that China is going see oil usage similar to America within a few decades and I think the same argument applies to anyone betting on consumer growth in those emerging markets.

A few good examples of the situation I am talking about is Diageo, largest spirits producer, and GM, the automaker. GM had spectacular growth in emerging markets like China and Brazil and yet it meant very little to the corporate parent. They just couldn't make enough money. An American may buy a car for $30,000 but a Chinese would buy it for $10,000 (I don't know the exact numbers but hopefully it illustrates the point.) Similarly, Diageo, which is seeing good growth (at least when I was following it) in places like East Asia and India is posting very low top-line growth. The negative growth of alcohol drinkers in Britain and Europe just cannot be overcome by the emerging markets--not any time soon at least.

One other thing to keep in mind--a point brought up by yourself and a few others--is that many of these companies are capturing the easy consumers right now. Life will get more and more difficult. Right now, quite a number of consumers in those developed countries buy these products due to aspirational reasons (for example, quite a number of people in India and the Middle East spend 3x their monthly income on fancy mobile phones whereas hardly anyone does that in developed countries.)

I have never looked at Coca-Cola deeply and since quite a few of you here are bullish on it and/or own it, maybe you can dig up the numbers and post how sales and profits breaks down across developed and developing markets. I suspect Coca-Cola is much further along the maturity curve than many others (since Coca-Cola was already dominant in emerging markets in the 80's) but it'll be interesting to see how much they earn from EM vs developed markets.

IGNORETHEMARKET: "Coca-Cola is particularly interesting because its moat is more likely to hold up in the future due to a few unique factors. First, Coca-Cola provides a very essential daily living need... "

I would actually say the opposite. The popular carbonated drinks are unhealthy and who knows how consumers will treat it in a decade. It could very well become like tobacco of the modern day (I'm not predicting this but just saying how unhealthy it is.) So I don't think it is essential at all.

Having said that, I believe Coca-Cola's growth these days comes from fruit juices, mineral water, and non-carbonated sports drinks so this may not matter that much. It would surprise me if cola consumption declines over the next few decades.

Although I don't think Coca-Cola's products are essential, I do think you touch on an important point. I recall Warren Buffett saying once that Coca-cola is a great product because it doesn't retain memory (or something like that.) If you drink it, you won't have a lasting impact; you won't hate it and ignore it forever or something like that.

batalha
Batalha - 3 years ago
On top of that, you'll find that the profits (in absolute $ and not in terms of margins) in the developed world is far higher than the developing and undeveloped world.I think this is very hard to generalize and maybe we could track the data somewhere. Many multinacionals had over the last couple of years up to 35% of their profits originated from Brazilian operations alone (GM included). A few others I can think of: Nestle, Avon, Abn Amro.
IgnoreTheMarket
IgnoreTheMarket - 3 years ago
Sivaram,

Thanks for your input. I don't mind at all if you debate any (or all) of my points. In fact, I strongly encourage the most challenging of arguments. This is very healthy because it forces investors to consider other perspectives, which either leads to further research, stronger conviction, or both. After all, there are opposing opinions on each side of every transaction.

Without getting into the specifics of emerging markets, you are roughly right about the major multinationals getting about 30% of their business there. I'm not sure about CL or PG off the top of my head, but I know KO earns much, much higher margins outside the U.S. (about double). In fact, KO earns about 80% of its profits outside the U.S. So again, one could assume very low penetration rates in densely populated emerging markets and extrapolate great opportunity. Now, it won't necessarily be high growth because of the large existing profit base, but it should be enough to potentially offset the weakness in developed markets.

A couple other things to keep in mind... and this relates more to KO than some other brands, but many retailers are using these key brands as loss leaders to attract shoppers. It's hard to attract shoppers to your store with deep discounts on already inexpensive private labels. Also, many consumer products companies have been shifting to a tiered "good, better, best" product portfolio for key products. This should help dampen the effects of private label competition.

Something else strikes me about your position. If your doubts about consumer brands in developed AND emerging markets turn out to be true, that would indicate highly deflationary conditions for the global economy. In such as scenario, there aren't many businesses that would thrive in those conditions. If you know of some, please share your ideas.

Consequently, I am not "all in" on the success of consumer brands in emerging markets. The model portfolios I post on my website are currently about 30-50% cash. I think that's important to note since no one has commented on the investment outlook for these consumer brands, just the business outlook. With current challenges leaving a wide range of probable outcomes and fat-tail risk, profitable investment is even less certain than profitable growth... even for the best businesses in the world. There are risks in any investment, but given current prices and conditions, I have much more confidence in leading consumer brands than many other businesses.

Again, at the risk of being too verbose, I will end this comment here.

Thanks again for the quality (and opposing) input.
Sivaram
Sivaram - 3 years ago
I had some time and took a quick look at Coca-Cola...

Coca-Colas breaks down their figures as follows. The breakdown isn't exactly along emerging markets vs developed markets but it would look something like this:

(note: I'm counting 50% of Pacific as developed since it includes NZ and AUS; all this excludes bottling operations)




URL: http://www.thecoca-colacompany.com/ourcompany/ar/pdf/2009-operating-group-all.pdf

Europe

Revenue: $4,308

Operating Income: $2,946




LATIN AMERICA

$3,700

$2,042




North America

$8,191

$1,699




Pacific

$4,533

$1,887

EURASIA & AFRICA

$1,977

$810


TOTALS

Revenue

EM (approx) = $7.9b

Developed = $14.8b

Operating Income

EM (approx) = $3.8b (margin: 48%)

Developed = $5.6b (margin: 38%)

Basically, it looks like Coca-Cola earns roughly double its sales from developed, as that of EM. In terms of operating income, it earns roughly 40% in emerging markets.

Coca-Cola is likely more diversified than many other multinationals since it has had a dominant position in those countries for several decades now. So I think it will grow slower than some multinationals who just entered EM recently.

So, the question is how long will it take to basically double EM sales?

Based on these numbers, I would say the company is still heavily reliant on the developed world. If sales drop 5% in developed countries, it has to go up 10% in developing world (roughly speaking.) In terms of operating profit, it isn't as sensitive to developed world but it's hard to say if that's a more realistic picture.
Sivaram
Sivaram - 3 years ago
IGNORE THE MARKET: "If your doubts about consumer brands in developed AND emerging markets turn out to be true, that would indicate highly deflationary conditions for the global economy."

Just to be clear, let me say that growth in developing countries will be strong (obviously it has to be since their economic growth rate is much higher.) All I'm saying is that it likely won't provide much offset against any adverse developments in the developed world.

Furthermore, I'm not saying this is the end of Coca-Cola or anything like that. I just think that their profit margins won't be so good if the developed world enters a "slump." Their 20% ROE and continuously strong increase in dividends likely won't continue. Basically, the glory days of these companies are over. Yes, this sounds like a ludicrous call but let's see how things turn out.

I lean towards deflation but I don't think it will be severe in most of the world. There are only pockets of regions where deflation can be severe (such as China--since I believe they have massive overcapacity in fixed assets and manufacturing.) Instead, what I think may unfold is a long slump, kind of like Japan from 1990. However, the situation won't be as bad as Japan because a big chunk of Japan's problems are tied to rigid business culture and horrible demographics.

Do note that I have held this view for a while now and been completely wrong. So take it for what it's worth...

IGNORE THE MARKET: "In such as scenario, there aren't many businesses that would thrive in those conditions. If you know of some, please share your ideas."

It's going to be tough. Companies like Coca-Cola actually haven't posted good returns in the last decade. The reason obviously is because their share price was in a bubble in the late 90's (the growth bubble.) But what I'm arguing here is that the underlying business is going to see deterioration. Even though Coca-Cola's share price is way below the 1998 peak, its underlying business has actually done well. I have a feeling the business itself will weaken.

If what I say actually transpires, it'll be interesting to see how the market values Coca-cola over the next decade. Ten years ago, the business was doing well but the share price was overvalued. Right now, the share price isn't that overvalued but there is a real prospect of weakening business.

Anyway, to go back to your question, if we get into a slump of sorts, investing will be tough. I really don't know what will do well. One deflationist I follow, Gary Shilling, has suggested that companies that increase productivity may be an area to look. His thinking is based on the view that, if top-line sales cannot easily grow, then companies will try to increase profits by cutting labour or attempting to increase productivity.

Another area to look at, if you believe in deflation, are growth stocks--not what masquerads as growth but true growth stocks. These are companies that are creating new markets or expanding it in ways never thought of before. For example, Coca-cola fans may be interested to know that Coca-Cola was a top performing stock during the Great Depression. Back then, Coca-Cola wasn't like now and it was actually a growth stock that "invented" a new market (soft drinks.) Companies like Apple and Amazon are modern equivalents (albeit wildly overvalued and not worth investing in right now.)

Another approach is to pursue very conservative Benjamin Graham investing methods. If income statements don't produce much wealth, balance sheets may become more popular.
halis
Halis - 3 years ago
Sivaram,

The per capita income in even the fastest growing sizeable emerging markets, like China, is a fraction of the developed world. It will take 100 years to reach anywhere near the American income.

You are technically predicting the per capita income in China as compared to the per capita income in America in the year 2110. So you are predicting two growth rates, for two countries on the opposite side of the planet, for no less than 100 years. My opinion only, but don't do this kind of thing.
cm1750
Cm1750 premium member - 3 years ago
It may take decades for China to match the U.S. per capita income.

However, the important point is that consumer staples companies do not need income parity to significantly expand their sales.

As GDP grows in developing markets, disposable income levels will rise, likely benefiting the consumer staples companies that have established operations in emerging markets like China and India. After providing for basic necessities of shelter and food, staples are the next use of discretionary cash flow, as consumers start to buy these basic household items to enhance their quality of life.

Think of it in terms of Maslow's hierarchy of needs. As incomes grow, people will move up the scale from pure necessities (food) to products that PG, KO, PM and others provide - first soap and laundry detergent, then shampoo, then soft drinks, cigarettes and diapers, then snack foods and hair spray and so forth.

Incomes don't need to match those in the U.S. for the Chinese etc. to buy shampoo and diapers. Therefore consumer staples are a great play on growing but still moderate income in emerging nations.

LwC
LwC - 3 years ago
Actually IMO what Sivaram is doing when projecting the relative per capita incomes between U.S. and China may not be that out of line. For example, if one assumes GNP growth as a proxy for income growth (that is, per capita income will arise in proportion to GNP),and that current assumptions about GNP growth for the US and China will continue for a long time it is possible to project when China GNP will catch up to US GNP. I have read several attempts to project that point, and I have even run a few such scenarios myself.

Depending on what assumptions one makes, eg. China GNP growth will continue at the current rates or will moderate in a decade or two, and US GNP growth will continue at about the same average rate as the past couple of decades or will moderate, it is possible to project that China's GNP will reach parity in, say 25 to 50 years. (FWIW IMO China's GNP will moderate since it is not likely that their GNP will continue to grow at 10% +/- forever, and therefore the point of parity will likely be 40 years or more from now.)

The point is, whenever China's GNP reaches parity with US GNP, China will still have four times as many people as the US, and therefore IMO it's fair to assume that China's per capita income will be about one-fourth of US per capita income. Therefore it will take substantially more time for China's per capita income to reach parity with the US than it will take for China's GNP to reach parity with the US's. WIth these assumptions, a hundred years or more IMO is not out of the question since China's GNP would have to reach four times the US GNP for per capita incomes to reach parity.

halis
Halis - 3 years ago
My point is that, I can't predict growth rates one year out with any amount of certainty. 100 years is a fantasy and those assumptions are pointless to make. It would be like trying to predict that Japan would be one of the world's largest economies back in 1910.

I think a good indicator in China, as to growth in discretionary spending, is looking at LFC or China Life Insurance Company. Revenue has multiplied 6 times in 7-8 years and they are not the only life insurance company in China.

In my mind, if sales in life insurance products are increasing at a generous rate, then things lower on the spectrum will be increasing as well (ie soda, deodorant, etc).

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