Category: Value investing

What do Amazon, Apple, and Google have in common?

Apart from being some of the largest technology companies in the world, of course.

They all have what Warren Buffet referred to as economic moats.

Competitive advantage – Moat

A company’s economic moat is a long-term competitive advantage a company has over the competing firms. An economic moat can be thought of as an intangible asset – you can’t see it, but they’re key in the success of a company. An economic moat is a durable competitive advantage that sets the company apart from its peers.

Think about the wide and deep trenches surrounding the medieval castles. It protected the castle and the kingdom from enemies. That’s where the word moat originated from.

Just like the trenches, the economic moat helps the company to protect its market share and long-term profits from its competing firms.

Why are moats important?

Having an economic moat is key to the success of a company.

Take Coca-Cola (KO) for example. Their secret recipe is just one of their economic moats. And with that recipe, Coca-Cola sold its soft drinks in every part of the world. And none of their competitors could imitate Coca-Cola’s success, since they didn’t know the recipe.

There have been hundreds of soft drink manufacturers around the world since Coca-Cola first came out. But none has managed to overcome or even imitate Coca-Cola’s success.

Economic moats can help companies dominate a market, resulting in a consistent increase in long-term profits.

As an investor, investing in companies with multiple economic moats is a fail-proof way to generate maximum profits in the long run. As these companies maintain their market share, their earnings will continue to rise, so will the stock price.

How are economic moats created?

Economic moats are created when a company is able to distinguish itself from the rest of its competitors. This distinct advantage could be anything from pricing power to high switching costs.

Walmart is a great example of an older form of an economic moat. By economies of scale, Sam Wolton (Founder of Walmart), was able to grow Walmart into a retail giant, with 10,500 stores spread across 24 countries.

Economies of scale are defined as the ability of a company to sell its products at the lowest possible cost. Walmart achieved this early on in the business, thanks to its large number of stores. The key being Walmart’s ability to buy the merchandise in bulk, at significantly lower prices. As for suppliers, doing business with Walmart meant greater exposure to their products. Besides, Walmart was buying merchandise in huge quantities, which even with a discount, was profitable for the suppliers.

And this in turn allowed Walmart to sell the products at a lower price than their competitors. Thus an economic moat was achieved through economies of scale.

Types of competitive advantages

Walmart’s example shows an earlier type of economic moat. With the rise of technology, in the last decade, economic moats have been created by leveraging different aspects of a business.

Here are some of them.

Network effect

A company, product, or service has a network effect when an increase in the number of users increases the value of its services. The value increases proportionally with the number of users.

An earlier form of network effect can be found on telephones. When telephones were first introduced, only a few people owned them. So there weren’t many people you could talk to using a telephone. But once more people started using it, the value of the telephone increased, as now there were more people you could talk to. So more people started buying telephones.

The same goes for social networks.

Facebook, for example, grew using this network effect. As more people started using Facebook, the company got more data on how people used the platform. That helped Facebook in making improvements, which in turn drove more people to the platform. This flywheel is the reason why Facebook has 2.85 billion users.

A network effect is an example of a wide economic moat. If a company has a wide economic moat, it means that its competitors will have a hard time entering or competing in the market.

On the other hand, if a company has a narrow economic moat, it means that the competitive advantage may not be sustainable. Or a competitor might be able to overcome the moat. An example of a narrow economic moat would be the one created with patents that expire in a year or so.

Cost advantage

We’ve already seen how Walmart used the cost advantage to become the retail giant it is today. Similarly, companies create moats using various advantages related to cost.

Amazon, for example, created a moat for Amazon Web Services (AWS) both using economies of scale and high switching costs. We’ve already discussed economies of scale, so let’s see what switching costs are.

Switching cost is the cost that a customer incurs when switching from an existing service to a new one. Consider the example of banks. Sure, there are no fees to be paid for switching from one bank to another. But imagine the struggles of having to transfer your entire portfolio of assets. And don’t forget the paperwork. Often, the hassle is simply isn’t worth it. Thus, once a customer gets accustomed to a bank, he/she is unlikely to switch.

And the same goes for AWS. Once you get your website and other services running on AWS servers, it simply isn’t worth switching. Remember, we’re talking about large amounts of data here. Besides, AWS provides you with everything you need; machine learning, analytics, AR/VR, robotics. And the more services you use, the more difficult it is to transition to a different cloud provider.

This has helped AWS capture market share, and keep it. Even in 2021, they continue to dominate the cloud computing market with a share of 32% compared to 19% for Microsoft’s Azure and 7% for Google Cloud.

Brand value

Companies can use their brand value to create a moat. Brand value is nothing but the perceived value of the company by the public. This brand recognition allows the company to charge a premium, without losing market share. This can be achieved through some form of unique value proposition, messaging, and culture.

And if they can use the brand value to create customer loyalty, it’s an added benefit. In fact, brand loyalty can ensure dominant market share and consistent revenue.

Case in point, Apple Inc.

Just to illustrate the power of Apple’s loyal customers, here is a survey by SellCell. According to the survey, 91.9% of iPhone owners plan to buy another iPhone when they next upgrade, up 1.4% from 2019.

So how exactly did Apple achieve this level of loyalty?

For starters, Apple always had a strong and unique value proposition; creating personal experiences with the help of technology. They weren’t just making smartphones and computers, they were creating iPhones and Macs.

You might argue that they are just fancy names for an average product.

But when their customers want to buy a smartphone they don’t go like “I want this because it has 4 GB RAM, Quad-core processor, and 64 GB internal storage. Instead, they think; “I want this because it’s an iPhone.

Moreover, Apple created its brand around emotion. It got to the point where having an iPhone makes customers feel sophisticated. That’s the reason Apple continues to dominate the smartphone market even when there are better phones in the market, both in terms of technology and price.

This brand value allows Apple to charge a premium price, without losing market share to its competitors. Owing to that, iPhone sales contribute to half or more than half of Apple’s overall sales revenue, in recent years. It accounted for 48.6% of Apple’s total revenue in the third quarter of the company’s fiscal year 2021.

Intellectual property

While some companies build their brands through brand value and cost advantages others do so by leveraging internal resources, expertise, and legal protections.

These intangible assets are referred to as intellectual property.

Intellectual properties include patents, licenses, unique technology, etc. that are legally protected by intellectual property laws. This prevents competitors from replicating or using those properties. This allows companies to use these properties to create products or services, which can bring in a lot of revenue, as the competitors can’t replicate it.

Intellectual properties also include any form of copyrights and trademarks. For example, Disney has a lot of intellectual property in the form of all the animated characters it has created over the years. Mickey Mouse, one of the most popular characters in the Disney Universe, has been bringing in revenue from merchandise sales even years after the show ended.

Qualcomm is another example of a company that created a moat with intellectual property. The company has a massive patent portfolio with over 130,000 issued patents and patent applications around the world. They achieved this through huge and consistent investments in R&D over the years. The patents are mostly related to technology, such as 5G, wi-fi, Bluetooth, and mobile operating systems. This powerful moat has enabled them in achieving a 40% market share in baseband processors.

Qualcomm also licenses these technologies to other companies. And that has brought a huge source of revenue over the years. It is also a highly profitable business as the costs are limited. Qualcomm’s licensing division reported over $5 billion in revenue in 2020.

Identifying Moats

It is often difficult to identify an economic moat when it is being created. It becomes more clear in hindsight, as the company reaches major heights. But still, if you observe closely, you will be able to identify the significant advantage of a company.

An important aspect that distinguishes an advantage from a moat, is sustainability. The moat should be sustainable. If it is something competitors can replicate, the moat wouldn’t last long. And the longer the company can keep the moat, the greater the profits. So whenever looking at a company make sure the competitive advantage is sustainable.

An efficient products and services ecosystem is another sign that a company might be creating a moat for itself. Especially an ecosystem that benefits from the network effect that we discussed earlier. This is more often found in internet companies.

Another sign that a company is achieving a moat, is when the name of the product or service becomes a verb, or sometimes the category itself. Take Google for example. Nobody search for stuff on the internet anymore – they ‘Google’ it.

Bottomline

Successful companies are built on sustainable competitive advantages. So as an investor it makes perfect sense in looking to companies with economic moats. That’s not to say that every company that does have a moat will be a bad investment. Just that investing in companies with a moat increases the odds of substantial profits from the investment.

As a comprehensive continuation to this article, we’ll soon be releasing a book on Moats; how to identify a moat while it is being created, how to approach companies with an established moat, etc.

To make sure you don’t miss out on the book, join our newsletter here.

Value investing is one of the most popular investment strategies. The stock market has rewarded value investors with exponential returns. No wonder why so many new investors are intrigued by this successful strategy.

However, there is one aspect that many investors look over and fall prey to – the value trap.

Let’s see what it is.

What is a value trap?

It is precisely what the name says – a trap.

Value traps are stocks that seem like value stocks but are actually traps in disguise. These stocks will be trading at low stock prices relative to what is considered as their fair value (or book value), and will also have valuation ratios in lower multiples. This will trick an investor into thinking that it is a value stock available at a discount.

Value traps appear to regular investors as potential winners, especially for value investors who are looking to buy stocks on a bargain. But in reality, these stocks often have very little promise, and possibly no future. Investors on seeing this ‘opportunity’ rush to buy these stocks end up losing their money.

The catch here is that the stock price is low not because it is trading below its intrinsic value. It’s just because the company doesn’t have much potential and is likely to be on its way to bankruptcy.

How does a stock become a value trap?

To understand this, let’s first look at how a regular stock becomes a value stock. This happens when a stock that has strong fundamentals and huge long-term potential trades below its intrinsic value. This might be because the market hasn’t realized the stock’s true value, and when it does, the stock price rises above its intrinsic value, and the investor makes money.

However, in the case of a value trap, the stock might be trading at a low price because of different reasons. It might be the case that the company’s long-term outlook has changed, or is about to change due to reasons that are not immediately apparent. The stock might appear to have good fundamentals, but there are underlying issues that could potentially affect the long-term prospects of the company.

For example, a company losing market share to a strong competitor might be at the risk of losing out revenue and profits – which could have a negative impact in the long run. But this might not be obvious in the income statement or balance sheet.

Value trap indicators

There are various instances where a stock might end up being a value trap. A factor that indicates that a particular stock might be a trap is referred to as a value trap indicator.

Let’s look at each in detail;

Earnings and cash flow

Income and cash flow statements are something every investor looks at when analyzing a company’s fundamentals. However, an income statement or a cash flow statement doesn’t tell you the whole story. A company can have good earnings and still go bankrupt.

Consider the case of some investment banks at the time of the financial crisis during 2008-2009. These institutions were funding long-term liabilities with current assets. So their financial statements looked healthy, but they were hanging by a thread. Soon enough, most of these institutions went bankrupt, and the shareholders were wiped out overnight.

Business model

This is something that many investors neglect and as a result, can lead you right into a value trap.

In a nutshell, understanding the business model involves finding the answer to three questions; a) how do they make money, b) how do they spend their money, and c) and what makes them any different from a competitor.

If there’s a company whose business model is hard to understand, and you can’t find a path to profitability, it might not be worth investing in it. Another question to ask  – is the business model sustainable? Meaning can it withstand a recession, technological advances, etc.

Walmart is a great example of a company that can withstand a recession and technological disruption.

Major changes in the industry

Changes are inevitable, and they happen all the time – some of them are obvious, while some aren’t. Major changes in an industry can change the long-term outlook of a company, in a short period of time. More importantly, these changes won’t be reflected in the financials of the company until a few quarters or years later. Meanwhile, investors will rush to buy the stock as it seems cheaper compared to its previous prices.

Airlines are a good example of this. The global pandemic brought a lot of change to the airline industry – because people stopped flying. And then people found a way to reach one another without traveling hundreds of miles – using Zoom and other video conferencing platforms. If you were an investor who has been waiting to own airline stocks, you see the price decline the pandemic has caused, and you jump at the opportunity.

Guess what, you’ve just fallen prey to a value trap.

Peak earnings or cyclical industries

Then some companies belong to cyclical industries. A cyclical industry is an industry that is dependent on business cycles for revenue generation. So their profits rise and fall predictably. The businesses in cyclical industries, expand and contract, and expand and contract again – in cycles. Their ability to make money largely depends on the overall economic conditions. Hotels, textiles, and construction are some examples of cyclical industries.

When they go through a favorable period in the business cycle, their earnings might shoot through the roof. This results in a significantly low P/E ratio, which makes the stock appear largely undervalued. Now given the fact that most investors look at the P/E ratio to find undervalued stocks, suddenly these stocks might seem like a lucrative investment. However, investors fail to realize that this might be the first time they’ve had such results in years or even decades.

Management

This is another aspect of a company that gets lost in the world of numbers, ratios, and whatnots. Good management can build the company from the ground up and keep it growing, and a bad one can drive it right into the ground. The management makes strategic decisions that decide the long-term potential of a company. So be well aware when they are giving out signals.

Are the insiders buying shares? Or are they selling them? Do they have skin in the game – how much of the shares do the executive team members own? These are some questions you need to ask yourself, before jumping into a value stock – to make sure you don’t end up in a value trap.

Chewy – one of the stocks that we recommended has insider ownership of 21.99%. It means that about 22% of all the outstanding shares are owned by the company’s management, directors, promoters, etc. basically people who know best about the future of the company. Significant insider ownership ensures that they have skin in the game – they are accountable for their actions that drive the company.

Companies without a moat

Okay, you have checked all of the boxes above  – they have a good business model and management, they’re not in a cyclical industry – it all seems good. But are they any different from their competitors? More importantly, is there anything that sets them apart from their peers in the industry? What if a new competitor comes in – can they imitate what our company does – what if the competitor does it in a better way?

The point is – if they don’t have sustainable competitive advantages (also known as moats), that can set them apart from their competitors, they’re unlikely to survive competition over the long run. And they could just be another value trap.

Consider Apple for example. If you’re an iPhone user (or any Apple products for that matter), you know best about the edge Apple has over its competitors. Their brand value is just one of their sustainable competitive advantages that just cannot be imitated by their competitors – new or old. And if you’re not an Apple user, you know how the prices seem ridiculously high – but still, people line up outside their store whenever they launch a new product. That’s because of the pricing power that they have; they can charge higher prices than their competition and still get away with it, without losing market share.

How to use value investing to avoid value traps?

Now that we know the characteristics of a value trap, let’s see how you can avoid them.

Do your homework; thoroughly

I can’t stress this enough.

You need to do due diligence on any stock that you buy, and you need to do it thoroughly.

That means not just looking at the numbers, but doing a deep dive into their 10-K form, investor presentations, etc. When they hear about a stock for the first time, most investors quickly jump onto a platform like Yahoo Finance and take a look at all the numbers available – P/E, P/B, P/S, ROE, ROA, ROIC, etc. and decide whether its a good or bad investment.

Don’t get me wrong here; it’s a good idea to look at numbers, and Yahoo Finance is a great place to start – as it gives you a detailed look without being intimidating. But you shouldn’t make an investment decision solely based on that. Because that might just be the easiest way to end up in a value trap.

You see, the numbers only tell you one side of the story. There might be underlying issues that pose a risk to the future of the business – the company might be facing a lawsuit from their biggest customer, they might be losing market share, or their products are getting outdated, etc. Therefore, wait for a while to make sure you’re not buying on ‘instinct’. And in the meanwhile, take a look at their investor presentation – it is usually short and easy to understand. And if you’re still interested, take a look at their Form 10-K. That will give you a detailed look at the business and operations.

And always remember, if you can’t find some sort of negative information about the company, you haven’t looked deep enough. Now, this information needn’t necessarily be bad enough to sell the stock, but more like the kind of information that gives you a fair picture of the risks of investing in the company.

Bottomline

Investors should be well aware of the risk value traps pose. This is especially applicable for value investors, as they’re the ones who are more exposed to these. There is also the risk of buying stocks by looking only at dividend yield, only to end up in value traps.

It is important to note that, Warren Buffett, however, had the audacity to identify false value traps (which is nothing but a value stock) and make a lot of money. The important part is being able to tell the difference between a value stock and a value trap.

To know more about value investing and the 20 stocks you should buy for the long term, check out our bestseller The 8-Step Beginner’s Guide to Value Investing.