The topic of lecture four of Peking University's Fall 2020 Value Investing Course is economic moat. Needless to say, it is also a very important topic. Chang Jing spent hours discussing the core ideas, sharing a case study and answering questions.
Economic moat is an idea that was popularized by Warren Buffett (Trades, Portfolio). It is closely related to margin of safety and intrinsic value. Unfortunately, it is also inherently mostly qualitative and intangible.
Economic moat is what differentiates a good business and a bad business. A good business has some economic moat. A truly great business has a deep, wide and sustainable economic moat. A bad business, on the other hand, has no economic moat.
Good business vs. bad business
First of all, we have to have some basic idea about what is a good business and what is a bad business. There are a few frameworks to use. One good framework to use is Boston Consulting Group's matrix. There are four quadrants based on market share and market growth. It is a straightforward way to categorize businesses, as shown below:
Another framework to use is Jim Collin's idea of categorizing businesses into two styles: foxes and hedgehogs.
Both frameworks have their own advantages and disadvantages. There are other ways to separate good companies from bad companies, but it all boils down to economic moat.
Revisiting Greenwald's intrinsic value framework
In lecture one, Chang talked about Greenwald's three-element approach for intrinsic value calculation. Under this framework, a good company derives most of its intrinsic value from earnings power and growth. We also have to consider the sustainability and consistency of earnings power and growth power.
Earnings power arise from asset value and franchise value. In general, similar businesses utilize similar types of assets. For instance, all restaurants have to invest in tables, ovens, chairs, woks, etc. But similar assets may generate different revenue and profit profiles due to different operating capabilities. Franchise value is mostly independent from asset value. For instance, patent or regulation can give a business earnings power.
How do we calculate earnings power?
Using Greenwald's framework, earnings power can be calculated using the following formula:
Earnings Power Value = Earnings * (1/cost of capital) = Earnings Power Value of Business Operations + Excess Net Assets
Here, earnings equal reported operating income plus adjustments. Cost of capital equals weighted average cost of capital. Equity value equals earnings power value minus debt obligations.
Chang notes that there's a very important assumption: current earnings are infinitely sustainable. As mentioned in lecture one, there are three scenarios for earnings power and asset value:
Scenario 1: EPV < asset value. In this scenario, earnings power value is less than assets value because of an incompetent management team, terrible industry dynamics or both factors.
Scenario 2: EPV = asset value. This is the case in a perfectly competitive market.
Scenario 3: EPV > asset value. In this scenario, earnings power value is more than assets value because of the existence of moat, or superior industry characteristics, or a combination of the two.
Definition of economic moat
According to Chang, economic moat can be defined as the non-replicable, sustainable and structural competitive advantages and franchise power. The key words here are non-replicable, sustainable and structural. The competitive advantages have to meet all three criteria to be called an economic moat.
Franchise value and competitive advantages are both part of economic moat. Many investors think operating efficiency is a source of economic moat, but his is not the case. Operating efficiency can be a source of economic moat, but it has to be long-term sustainable.
Economic moat is closely related to intrinsic value and margin of safety. It can be the primary source of earnings power and growth value. Earnings power and growth value can be the primary source of tremendous intrinsic value. This is the case for Kweichow Maotai (SHSE:600519, Financial), which I discussed in my previous article.
All said, economic moat can be very tricky, especially for businesses with no current earnings.
Read more here:
- Notes From Peking University's Fall 2020 Value Investing Course - Kweichou Maotai Case Study
- Risk Events and Margin of Safety
- Qualitative Factors Affecting Margin of Safety
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