At Sanlam Private Wealth, our investment philosophy centres on price, which we believe to be the dominant factor driving investment performance over the longer term. However, we also want to own companies that can sustainably grow their intrinsic value by earning profits ahead of their cost of capital. Economic theory (backed by real-world experience) tells us companies that make super-profits will attract competition, which will in turn drive returns down to levels closer to the cost of capital. What makes a company valuable is whether it can continue to earn high returns relative to its competitors and other industries. It’ll be able to do this if it has a sustainable competitive advantage, or ‘moat’.
STAYING THE COURSE
Looking back over a 30-year period, however, not many of the world’s largest companies appear to have been able to stay the course. Of the list of top 10 global companies by market capitalisation in 1990, only one is still on that list today. Just two survive from 2000, and three from 2010. Environments and technology tend to evolve rapidly, and today’s heroes may well turn out to be tomorrow’s laggards.
The question is: how does one determine which companies will last, and which won’t? In other words, whether or not the competitive advantage a company enjoys at any given point will be sustainable over the long term? All listed companies will tell you what makes them special, but it’s up to investors themselves to determine which have durable, non-replicable competitive advantages, and which do not.
For most shares listed on the JSE, more than three quarters of their value is attributable to events that will take place more than four years into the future. Yet we know that predicting the future (particularly more than a year ahead) is fraught with danger. To help counter this, we need to paint in broader brush strokes when looking at companies, and rely on concepts more than specifics.
At Sanlam Private Wealth, a key part of our work centres on assessing how a particular company’s competitive advantage may change over time, either positively or negatively, and how this may impact its long-term profitability relative to current market expectations. We’ve identified more than 25 sources of competitive advantage, ranging from internal culture, technology, systems, exclusive rights and relationships, to location. However, we see only five of these as being sustainable competitive advantages:
- Network effects – think of the advantages enjoyed by Facebook and LinkedIn
- Switching costs – in terms of both money and effort. Imagine, for example, moving your entire office away from Microsoft products
- Brand/patent strength – Coke, Ferrari, Cartier, Merck and Pfizer come to mind
- Economies of scale – such as those enjoyed by Amazon, Toyota and Walmart
- Licences – ensuring a limited number of players in the market. Think Vodacom or Sea Harvest.
NETWORK EFFECTS
The most powerful of these advantages is network effects – the more customers you have, the more it makes sense for new customers to join you. The simplest example is Facebook: any new user of a social network wants to join the one where the most potential connections are available. The idea is the same for classifieds companies such as Property24, Gumtree and Naspers’s Letgo, or dating network Tinder.
For network effects to be advantageous, companies need downward-sloping average cost curves – something the global tech giants all have. Technology enables them to add new customers for virtually zero marginal cost, so these companies have escaped the logistics problems facing traditional multi-nationals selling physical goods. Given higher confidence in the long-term cash flow generation of such companies, investors are prepared to pay higher multiples.
Companies with strong network effects are often natural monopolies. With this comes the opportunity for ongoing super-profits (Facebook has a 45% operating margin), but it also attracts the attention of regulators. History shows governments tend to want to break up or limit monopolies, but politicians may struggle to argue that free services to consumers constitute an abuse of monopoly power.
On the JSE, there’s only one company with genuine network effects: Naspers (Tencent has over a billion users, and it has strong network effects in its classifieds businesses). Unsurprisingly, it’s among the largest, and trades at a high multiple. Most of the other large SA-listed companies rely on economies of scale and brand which, although sustainable, are weaker forms of competitive advantage.
On our proprietary scoring system, Naspers consistently fares best, while a company like Kumba, on the other hand, has almost no sustainable competitive advantage, given its small scale in the global iron ore space.
While valuation will always be top of mind when we at Sanlam Private Wealth build an investment thesis around a particular asset or share, determining whether it has a sustainable competitive advantage is one of the ways we seek to understand the asset better. It ensures we have the correct long-term perspective on the asset.
