I agree. While valuation matters, it is the future growth and prosperity of the company underlying a stock, not its current price, that is most important. A company's prosperity, in turn, is driven by how powerful and enduring its competitive advantages are.
Powerful competitive advantages (obvious examples are Coke's brand and Microsoft's control of the personal computer operating system) create a moat around a business such that it can keep competitors at bay and reap extraordinary growth and profits. Like Buffett, I seek to identify -- and then hopefully purchase at an attractive price -- the rare companies with wide, deep moats that are getting wider and deeper over time. When a company is able to achieve this, its shareholders can be well rewarded for decades. Take a look at some of the big pharmaceutical companies for great examples of this.
Don't Confuse Future Growth With Future Profitability
The value of a company is the future cash that can be taken out of the business, discounted back to the present. Thus, the key to valuation -- and investing in general -- is accurately estimating the magnitude and timing of these future cash flows, which are determined by:
- How profitable a company is (defined not in terms of margins, but by how much its return on invested capital exceeds its weighted average cost of capital)
- How much it can grow the amount of capital it can invest at high rates over time
- How sustainable its excess returns are
It's easy to calculate a company's historical growth and costs and returns on capital. And for most companies, it's not too hard to generate reasonable growth projections. Consequently, I see a large number of high-return-on-capital companies (or those projected to develop high returns on capital) today with enormous valuations based on the assumption of rapid future growth.
While some of these stocks will end up justifying today's prices, I think that, on average, investors in these companies will be sorely disappointed. I believe this not because the growth projections are terribly wrong, but because the implicit assumptions that the market is making about the sustainability of these companies' competitive advantages are wildly optimistic. Warren Buffett said it best in his Fortune article last November:
"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."
The Rarity of Sustainable Competitive Advantage
It is extremely difficult for a company to be able to sustain, much less expand, its moat over time. Moats are rarely enduring for many reasons: High profits can lead to complacency and are almost certain to attract competitors, and new technologies, customer preferences, and ways of doing business emerge. Numerous studies confirm that there is a very powerful trend of regression toward the mean for high-return-on-capital companies. In short, the fierce competitiveness of our capitalist system is generally wonderful for consumers and the country as a whole, but bad news for companies that seek to make extraordinary profits over long periods of time.
And the trends are going in the wrong direction, for investors anyway. With the explosion of the Internet, the increasing number of the most talented people leaving corporate America to pursue entrepreneurial dreams, and the easy access to large amounts of capital from the seed stage onward, moats are coming under assault with increased ferocity. As Michael Mauboussin writes in The Triumph of Bits, "Investors in the future should expect higher returns on invested capital (ROIC) than they have ever seen, but for shorter time periods. The shorter time periods, quantified by what we call 'competitive advantage period,' reflect the accelerated rate of discontinuous innovation."
Strategy
In this environment, how can one identify companies with competitive advantages that are likely to endure? It's not easy and there's no magic formula, but a good starting point is understanding strategy. In his article "What Is Strategy?" (Harvard Business Review, November-December 1996; you can download it for $6.50 by clicking here), my mentor, Harvard Business School professor Michael Porter, distinguishes between strategic positioning and operational effectiveness, which are often confused: "Operational effectiveness means performing similar activities better than rivals perform them," whereas "strategic positioning means performing different activities from rivals' or performing similar activities in different ways." When attempting to identify companies whose competitive advantages will be enduring, it is critical to understand this distinction, since "few companies have competed successfully on the basis of operational effectiveness over an extended period."
Professor Porter argues that, in general, sustainable competitive advantage is derived from the following:
- A unique competitive position
- Clear tradeoffs and choices vis-�-vis competitors
- Activities tailored to the company's strategy
- A high degree of fit across activities (it is the activity system, not the parts, that ensure sustainability)
- A high degree of operational effectiveness
-- Whitney Tilson
Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at [email protected]. To read his previous guest columns in the Boring Port and other writings, click here.
Related Links:
P.S. At the end of my column three weeks ago on Valuation Matters, I neglected to add links to two fantastic articles, both on the CAP@Columbia website (which is chock-full of brilliant articles -- and they're free!):
Mauboussin is a Managing Director and Chief U.S. Investment Strategist at Credit Suisse First Boston, and teaches the Securities Analysis course at Columbia Business School that Ben Graham used to teach. Johnson is a Managing Director in the Equity Research Department of Robertson Stephens, and is co-author of The Gorilla Game, a book I highly recommend.
