Andrew Kuhn April 18, 2020

What Makes a Business Durable?

What Makes a Business Durable?
Hey Geoff,
I noticed in one of the recent videos you mentioned that the durability of the business matters more then the returns. I believe you were answering a viewer question on return on capital for the subject matter. When you mention durability are you talking about recurring revenue, sustainability of the business going forward (like waste collection industry or railroads etc…)?
Answer: A Good Place to Start is With the Oldest Companies in the Oldest Industries
Yes. So, this is something Buffett has said before too – and it’s true. It’s the reason why I’m not a fan of “The Magic Formula”. The Magic Formula is a system that might work empirically – but, it isn’t based on sound logic. That’s different from something like the Piotroski F-Score or Ben Graham’s 2/3rds of NCAV rule. Both of those approaches are logically sound and then can be tested to see if they work empirically. I don’t think it’s a good idea to use a system that has been back tested to show good results, but that doesn’t seem logically sound. I’m unconvinced of the logic of The Magic Formula – because, it is basically buying high current return on capital stocks without asking if they have a moat. It’s not the Buffett approach. It’s actually very different from Warren Buffett’s approach. His approach is to figure out why a company has had a high return on capital in the past, has a high return in the present, and is likely to have a high return in the future. Once he knows the reason for the high return – the company’s “moat” – he can judge how durable that moat is. This is also similar – though slightly different – from the Phil Fisher approach. Phil Fisher’s approach focused more on the organization and whether it is built for the long run: is it investing enough in marketing, is it investing enough in R&D, does it have good enough people at lower levels in the organization, are the markets the company is in likely to grow for a long time to come, has the company had success releasing new products regularly to replace old products, etc. That’s very similar – though from a different angle – to the Buffett approach. Those two approaches – Buffett and Fisher – are qualitative looks into the future. We can debate how accurately a human being can judge the likely future of a company. But, the logic of trying to do that is sound. The logic of assuming that a currently high return on capital is less likely to decline than a medium or low return on capital makes little sense. There has been some research in this area and the answer is – it depends on the industry. Some industries do show high persistence of relative returns among the firms in those industries. So, for example, the leading movie studio or beverage brand or condiment maker might tend to earn higher returns on capital than other companies in the industry from one decade to the next. In some cases, we can see this did happen. Some of the leading paint makers, cereal makers, razor makers, etc. in the U.S. were the same 50-75 years ago as today. In many ways, their economics did not change. And, in cases where their economics changed, their relative returns in the industry may not have changed as much. In other words, the whole industry may have shifted toward worse returns – but the #7 cereal maker didn’t become the #1 and the #1 didn’t become the #5 and so on. The Magic Formula doesn’t take this into account. So, it is likely to pick cyclical companies – it could pick an oil producer, a copper mine, an RV maker, a mine equipment maker, a shipyard, a maker of computer equipment (like memory) etc. – when those returns aren’t cyclically adjusted. Even if the returns are cyclically adjusted – it could pick something tied to fashion risk like a clothing retailer. If the concept is popular for a time – the chain will earn high returns on capital. But, those high returns on capital will decrease more dramatically in the future. This causes a double whammy to the Magic Formula because it is a system that double counts peak EBIT. The two parts of the Magic Formula are EV/EBIT and EBIT/NTA. Therefore, a sharp drop in EBIT throws both halves of the formula out of whack. And, mean reversion suggests that unusually high EBIT is more likely to plunge than unusually low EBIT. That means the Magic Formula is pro-cyclical and likely to pick businesses that are “topping” in their industry cycle, their fashion cycle, their societal acceptance etc. Now, The Magic Formula is a trading strategy – not an investing strategy. It tells you to dump all these stocks after one year and buy new ones. So, it’s similar to – but not as logically sound – as the net-net approach. That’s also a “trading strategy” as opposed to a long-term investing approach.
Buffett’s approach – and Fisher’s approach – is long-term. So, it needs these businesses to be durable. That durability can come in several forms. One, some industries are more durable than others: banking, insurance, drugs, alcoholic beverage, non-alcoholic beverages, food away from home, food at home, entertainment away from home, entertainment at home, shelter, clothing, and transportation will be around in some form forever. The form can change. But, these are durable industries compared to some other ones. One way to check how durable an industry is likely to prove is simply to ask how old it is, So, how long have cultures been using cement to build things for – longer than 2,000 years. How long have cultures been packing into a theater to watch a show (play, movie, etc.) of some kind – over 2,000 years. How long have they been drinking alcohol – over 2,000 years. Gambling? Over 2,000 years. Eating at “grab and go” restaurants? Over 2,000 years. Staying at inns? Over 2,000 years. When were the first loans made, the first forms of insurance used, the first bank accounts used, the first advertising done, the first accounting done, the first lawyers used, etc. – all these things date back in form like 2,000 years or more somewhere in the world. They’ve greatly expanded over time and changed in form and so on. Most people would date the first banks to only like 700 or so years ago. That’s because some things about banking, accounting, etc. changed in such a way that we recognize the forms used 700 years ago as being like the ones we’re familiar with but not the ones done 2,000 years ago. In some other cases, it’s very recognizable. The use of cement 2,000 years ago and today is very similar and very easy to recognize as being similarly used. Hotels in the fancier sense of the word might date back only several hundred years to Europe. Restaurants – again, in the fancier sense of the table service restaurant – might only be dated back 200-300 years. Again, though, this is tricky. If we mean “street food” and “bakeries” and so on – those were extremely widespread in Roman cities (but not rural areas) 2,000 years ago. And cities held probably 25-33% of the Empire’s population at its peak. So, that means “fast food” was extremely widespread as an industry almost 2,000 years ago. The forms of many industries do change over time. Gambling, for instance. What people gamble on has changed dramatically. But – legally or illegally – people have bet on dice throwing, animal fights, and (human versus human) sporting events consistently for at least a couple millennia. Sports have proven pretty universally popular in time and space. Fascination with animals has as well. Animal shows, parks, circuses, zoos, aquariums, races, etc. have also been pretty universal in time and place. A lot of the things I mentioned above are pretty basic in terms of how they interest humans. They serve pretty basic needs/wants/desires etc. I didn’t mention sex. But, pornography and prostitution and match making have also been basically universal in time and place.
As you move upstream from consumers – durability often becomes trickier. Take even super basic human desires that people indulge in whether they are legal or illegal like food, drink, drugs, gambling, entertainment, dating, sex, pornography. The methods by which these things have been delivered have changed a lot. They sometimes change for legal reasons. They sometimes change for societal reasons. They sometimes change for technological reasons. It’s often not super clear if the changes are temporary or cyclical – rational or irrational. At times, modern countries have had shifts – they’re pretty slow, but you can see them in the data – from eating more meat to eating less meat, eating more red meat or less red meat, eating more of one kind of an animal or another, increasing sugar intake or decreasing it, increasing processing of foods to last longer / be safer etc. or decreasing processing of foods to be closer to the natural form of the food. Some of these things may have a pretty rational explanation – as the price of one kind of animal’s meat falls and another rises, people’s buying preferences shift with relative price changes. Others are matters of societal acceptance, fashion, etc. Sometimes the shifts are somewhat legal, somewhat societal acceptance. A good example is where, how, and on what people gamble. I don’t know that lotteries would be people’s natural choice of what to gamble on – but, they are government’s favorite choice of what to allow gambling on.
All of this only tells you what industries are likely to be around and relatively unchanged over a long period of time. That doesn’t help you much. For example, clothes will be around in 20 years – but will H&M be around? Shelter will be around in 50 years – but will mobile homes? Building material will be around in 100 years – but will cement? Gambling will be around in 200 years – but will casinos?
There are industries where potential disruption of this kind is near. But, in many cases – it’s not. So, take transportation. Could gas stations be disrupted by a switch from gasoline powered cars to electric cars – yes. And could it matter soon enough for you to choose not to invest in a chain of otherwise excellent gas stations? Again, yes. On the other hand, could there be a disruptive shift in alcohol consumption general to the industry of say spirits that could affect a particular business in that industry enough to make you decide not to invest? Honestly, no. Absent government regulation – like prohibition in the U.S. – there’s no shift that could happen fast enough industrywide to change the likely net present value of a stock you’re looking at enough to make you decide not to invest. Alcohol is durable as an industry.
That means – when looking at an alcohol stock – all you need to do to assess durability is to focus on the specific company’s competitive position within its industry. There are two well-known methods for looking at competitive position (or “moat”). They are “Porter’s Five Forces” and Morningstar’s “Economic Moat Rating”. If you want to build a checklist for judging durability – just use the 10 items on these two lists as your single checklist.
Porter’s 5 Forces
1) Threat of new entrants
2) Threat of substitutes
3) Bargaining power of customers
4) Bargaining power of suppliers
5) Competitive rivalry
Morningstar’s Economic Moat Rating
1) Intangible Assets
2) Switching Costs
3) Network Effect
4) Cost Advantage
5) Efficient Scale
If a company has some of these 10 advantages – the question is how long will they last. For example, most alcohol stocks you look at will have efficient scale versus new entrants. Most entertainment companies will have intangible assets. Most branded food and drink companies will have high bargaining power over suppliers (but not always as high bargaining power over customers).
Let’s take Hanesbrands (HBI) as an example. They make underwear, T-Shirts, athletic type clothing, etc. A lot of its is made from natural cotton directly and the rest from some sort of synthetic product based in some way on oil. So, Hanesbrands has high bargaining power over suppliers. Sellers of cotton and oil based products are selling a commodity that they can’t price higher just because the customer has a better use for it than most other customers do. Hanes won’t pay more for its cotton than struggling companies using cotton as an input will. The company is also generally using low skill workers in a variety of different countries. So, their labor and materials inputs are basically commodities while their output is branded. This is generally how big brands have good gross margins. Sometimes, “efficient scale” is added to it. Companies like Hanesbrands, Gildan, etc. may sometimes have large scale versus new entrants especially where they account for a large volume of a customer’s buying (Wal-Mart, Target, Kohl’s etc. get a very big portion of many categories from Hanesbrands) or produce a very high volume of essentially the same product in the same location. Think of Gildan’s blank T-Shirt business as an example. Although T-shirts are a commodity made from cotton – a new entrant can’t buy cotton any cheaper than Gildan, a new entrant doesn’t have the capital to build a big facility to produce the T-shirts in, and a new entrant – since they lack this facility – doesn’t have customer relationships that could fill orders for a big facility. This is the “chicken and egg” problem. The only way to produce T-shirts at the lowest possible cost is to have a big facility producing T-Shirts for a big customer. You can’t get the big customer without the facility to meet their needs. And, you can’t make a big facility economical without the big customer in place. In my experience, “chicken and egg” or two-sided advantages are some of the most durable. This makes “middlemen” of some kind attractive in many industries. But, it depends on the exact nature of the two sided advantages. Let’s take movies for a second. Movie distribution for blockbusters is a two-sided “chicken and egg” advantage. Why? Well, big U.S. movies – the biggest of the year – sometimes have production costs of $100 million to $200 million plus almost the same amount again in marketing costs. This means the best scale position in moviemaking in the world tends to be putting out a movie with a “total release” cost of $200 million to $400 million. That’s what’s called a “super project”. You need a big financial backer to make such a bet. Plenty of big backers exist. You could finance movies with hedge funds, diversified holding companies, banks, insurance companies, or governments. All those entities have enough money to make $200+ million bets on a diversified enough basis to back movies. So, the threat of new entrants should be high. But, it’s not nearly as high as it seems. To achieve the best scale possible for a single movie – you need distribution. So, you need to get on at least 3,000 screens in the U.S. on the same weekend. Also, you’re likely to only get 25-75% of your total box office from the U.S. So, you need to get distribution both in the U.S. and around the world. Movies are made that basically just play in the U.S., just play in some other big market, etc. But, they don’t have the scale needed to get the best returns. You also can’t make a blockbuster on spec. It’s not possible to just front $200 million and make a movie and then go and find distribution afterwards. Why not? Well, with just $200 million and no distribution it is difficult to sign up the highest paid writers, directors, and actors. Directors will want a good script. And highly paid writers prefer either to get a lot more than normal to write you a script – or, to have some assurance it’s a “go project”. Without a distributor, it’s not a go project – so, you’ll have to pay more for your script or get a lower paid writer to write it. Directors definitely only want to work on projects that will happen. And they’d prefer to start with a good script on a project that’s going to happen. The highest paid actors around don’t usually join projects unless a director they know, have worked with before, etc. is already on the project. Again, all these things could be overcome by paying a lot more money (an actor will take a much higher guaranteed pay day to appear in a movie they expect to be bad, to not play much in theaters in the U.S, etc. – same with directors and writers) or getting less of a choice of the talent you want making the movie. This is just one of many examples. But, it helps illustrate how an advantage can be durable. Historically, the position of big distributors of movies in the U.S. has been much more stable than the position of most companies in most industries. The leaderboard of Hollywood studios has changed less over the last 100 years than the leaderboards of most industries. And, for at least the last 50-60 years, the studios have been more middlemen than truly vertically integrated producers. There are several reasons for this. But, one very basic one is that any business like this – movie distribution, music publishing, videogame publishing, etc. – benefits from 3 things: 1) A back catalog to produce cash flows from something other than current projects, 2) Launching properties of a bigger average size, 3) Launching more projects (to fully utilize your resources). It is extremely inefficient to try to distribute a couple small movies, a couple small video games, a couple small books, a couple small albums, etc. a year. Efficient scale is a high throughput of bigger and more frequent projects. And a back catalog provides a consistent source of funding.
I went through this long example, because it’s one of many things in that list of 10 competitive advantages that can be confusing. I mean is the “threat of new entrants” and the “efficient scale” in things like movies high or low. History says threat of new entrants is low and efficient scale is high. However, most people I ask say “threat of new entrants” in the movie business is very high. After all, it’s not difficult to make one movie. If we put aside quality – anyone can produce a movie on a shoestring. If we add quality into the mix – it’s expensive, but there’s no reason a non-Hollywood entity couldn’t wave around enough cash to get a movie made. Getting it distributed is a bit harder – but, assuming you have an expensive, high quality film already made it should be theoretically possible. However, you are going to pay more at every stage – including giving the distributor a bigger take than other studios do to get all this stuff. A new entrant is disadvantaged at every step of the process. Plus, a new entrant is risking everything on one roll of the dice. It’s better to produce 12 movies than 1 movie. The risk of getting burned by one bad movie experience is pretty high. In general, super projects tend to be safer from new entrants than economic theory would suggest because the risk taking required to fund super projects is psychologically unpleasant for the new entrant. For example, the best way to enter the movie business would be to have a lot of funds ready to deploy and to invest in a series of like 5 movies – learning from your experience as you go – and putting to work more like $500 million to $1 billion over a period of more than 5 years. Logically, you can look at the economics of movies and say – that’s the way this should be done. It is, not, however how anyone chooses to enter the business. They either choose to enter with very, very small movies or with co-productions or by acquiring an existing business. The experience of losing everything on movie one, breaking even on two and three, losing on four, and then making a huge killing on the fifth movie – or the same outcomes in a different sequence – just isn’t something your average business can stomach. What a new entrant wouldn’t do is the thing that’s probably the logically best approach given the economics of the business – they should start up a new department with a very talented person hired to head it and entrust that person with $1 billion or more to be spent over a period as long as 10 years to put out around 5 movies – and make sure everyone is 100% confident they will stick to the plan no matter how bad early losses are. That’s the “moat” around new entry.
One area that isn’t talked about in that list of 10 items is the “habitable zone” of an industry. If you are looking at a company’s durability, the durability of any position it occupies in an industry will be greater to the extent there are fewer (and smaller) “habitable zones” left in the industry. It’s impossible to stop new entry in restaurants, because the number and size of habitable zones is too great. There are one location restaurants making a living. That means any one location concept can snowball into a competitor. Meanwhile, the habitable zone for many brands, a lot of software, etc. is pretty bad. It’s not easy to make a small brand of cereal or ketchup profitable. This means you’d have losses in early years. While there are definitely some venture capital backed companies of the last 10 years or so that go against this theory – the best protection against competition is several years of start-up losses between you and them. Very few companies – and almost no small companies – are willing to endure years of losses between now and profitability. So, business that require a well-known brand, sufficient scale, large customer relationships, etc. are often better protected. A long sales cycle is helpful. Products that can be spread for free via the internet and stuff are more concerning. It seems easier to me that you might misjudge whether 100 million people will sign up for some app offered free with a premium feature that brings in the money versus whether 100 major corporations will switch their law firms, accounting firms, ad agencies, banks, etc.
This gets to the topic of switching costs. One thing to be careful of is that “switching costs” is a misleading term. The decision of someone to switch or not is a trade-off they are making between the cost and the benefit. It depends heavily on how much rational thought they are giving to switching. For example, the best protection against a customer switching is just to never have them enter “search mode” for a replacement. Most insurance customers don’t go back online and look for new quotes before they renew with their insurer. So, switching is less likely than “switching costs” would suggest. Likewise, there is no switching cost getting away from using Google. There is no switching cost getting away from the brands you buy in a supermarket or anything you smoke or drink. But, few people will switch. Why?
Your use of Google is not conscious – it’s habitual. If it was conscious – you’d consider: should I use another search engine. You never do. If a search took 10 minutes to spit results back at you, if you only did searches once a week, if you only ever searched at work, and if Google charged you 5 cents per search instead of just pushing ads on you – you’d consider switching. But, Google doesn’t do that. It makes the experience frictionless. A repeated, frictionless (seemingly “costless”) action you take will become habitual. So, although Google would be rated as having basically “no switching costs” it is actually something you are far less likely to switch away from. Therefore, the checklist item “switching costs” should say something more like “chance of switching”. There are two ways you might have a near zero chance of switching something. One way is you consider switching and determine the cost is too high. The other way is you never consider switching. As a rule, never considering switching is the safer defense. So, habitual use is often the highest switching cost of all.
So, what you want with any stock you are going to hold for the very long-term is:
1) The industry as a whole is likely to be around and look much the same pretty much forever
2) The company’s competitive position within that industry is likely to look pretty much the same forever
So, think of what industries have been around since 1920 or earlier. And what companies in what industries have been around since 1920 or early.
Now, you could argue that some new industries will be around for the NEXT 100 years even though they weren’t for the last 100 years. That makes sense to me. But, if the business isn’t much of an extension of a prior proven to be durable business – then I’d be careful. Google and YouTube and Facebook and Netflix are new enough. But, the way people use them aren’t very different from media outlets like newspapers, radio, and TV. Much of the economics are the same. In fact, the first several I named have pretty much exactly the business model of newspapers and TV in the sense of being supported by advertisers and trying to aggregate large amounts of cheaply produced content instead of trying to get a lot of subscription revenue from users in return for expensively produced in-house stuff.
I mentioned some exceptions to this rule – like cement companies – but, the other thing to focus on is: how far downstream is this company? The further upstream a business is – the further away it is from the eventual consumer – the more careful you want to be when judging durability. A winemaker is probably more durable than a cork maker or a wine cask maker. A carmaker is probably more durable than a gasoline refiner or a crude oil producer. This isn’t always the case. But, it’s usually easiest to evaluate durability when the business is close to the customer and there’s an important psychological element present in the decision making. This does mean that you’ll have to ignore large sections of all stocks as not being durable. In fact, if you really took this approach: your focus might be like 50% on consumer non-cyclical stocks with some business services stocks and maybe a very, very few basic materials stocks. Almost nothing else is as durable as those groups. In particular, non-cyclical consumer focused businesses tend to be unusually durable. And, as a rule, service businesses serving other businesses have pretty high durability too. Very basic stuff – like natural resources – are also durable. Many of these are globally traded commodities. But, not all. So, you could count some natural resource companies as being durable in the same way as business services and non-cyclical consumer products. Those are the 3 groups that tend to be durable. Note that some lists of companies/industries will separate financial services into its own group and entertainment/media. Obviously, financial services and media/entertainment are two of the most durable industries around.
Ask Geoff a Question of Your Own