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206-More on Competitive Positioning
  Course 206:
  More on Competitive Positioning
  In the previous lesson, we reviewed the different types of defenses (economic
  moats) and offered examples of wide-moat firms. Understanding moats, and
  determining whether or not a firm has a moat is a tricky process. In this
  lesson we'll examine the mental model that underpins our moat framework and
  explore some of the nuances of wide moats, narrow moats, and deep moats.
  
  
  Porter's Five Forces
  Michael E. Porter's Competitive Strategy, originally published in 1980, is a
  definitive work on industry competition. In the book, the Harvard professor
  provides a framework for understanding competitor behavior and a firm's
  strategic positioning in its industry. Much of Porter's framework should be
  familiar as it underpins our thinking about economic moats.
  
  In essence, Porter provided a framework of five forces that can be used to
  understand an industry's structure. Since firms strive for competitive
  advantage, the first four forces at work help to assess the fifth, an
  industry's level of rivalry:
  
    Barriers to Entry. How easy is it for new firms to start competing in a
    market? Higher barriers are better.
     
    Buyer (Customer) Power. Similar to switching costs, what keeps customers
    locked in or causes them to jump ship if prices were to increase? Lower 
    power is better.
     
    Supplier Power. How well can a company control the costs of its goods and
    services? Lower power is better.
     
    Threat of Substitutes. A company may be the best widget maker, but what if
    widgets will soon become obsolete? Also, are there cheaper or better
    alternatives?
     
    Degree of Rivalry. Including the four factors above, just how competitive is
    a company's industry? Are companies beating one another bloody over every
    last dollar? How often are moats trying to be breached and profits being
    stolen away?
  Porter's five forces considered together can help you to determine whether a
  firm has an economic moat. The framework is particularly useful for examining
  a firm's external competitive environment. After all, if a company's
  competitors are weak, it may not take much of a moat to keep them at bay.
  Likewise, if a company is in a cutthroat industry, it may require a much wider
  moat to defend its profits.
  
  
  A Five Forces Example: Consumer Products
  The five forces concept is perhaps best explained through example. (Porter's
  work is nothing short of excellent, but it is a heavy read.) Let's briefly
  examine the household consumer-products industry by considering rival firms
  Clorox CLX, Kimberly-Clark KMB, Colgate-Palmolive CL, and Procter & Gamble PG
  in terms of Porter's five forces:
  
  Buyer Power. Consumer-products companies face weak buyer power because
  customers are fragmented and have little influence on price or product. But if
  we consider the buyers of consumer products to be retailers rather than
  individuals, then these firms face very strong buyer power. Retailers like
  Wal-Mart WMT and Target TGT are able to negotiate for pricing with companies
  like Clorox because they purchase and sell so much of Clorox's products.
  Verdict: Strong buyer power from retailers.
  
  Supplier Power. More than likely, consumer-products companies face some amount
  of supplier power simply because of the costs they incur when switching
  suppliers. On the other hand, suppliers that do a large amount of business
  with these companies--supplying Kimberly-Clark with raw materials for its
  diapers, for instance--also are somewhat beholden to their customers, like
  Kimberly-Clark. Nevertheless, bargaining power for both the firms and their
  suppliers is probably limited. Verdict: Limited supplier power.
  
  Threat of New Entrants. Given the amount of capital investment needed to enter
  certain segments in household consumer products, such as manufacturing
  deodorants, we suspect the threat of new entrants is fairly low in the
  industry. In some segments within the household consumer-products industry,
  this may not be the case since a small manufacturer could develop a superior
  product, such as a detergent, and compete with Procter & Gamble. The test is
  whether the small manufacturer can get its products on the shelves of the same
  retailers as its much larger rivals. Verdict: Low threat of new entrants.
  
  Threat of Substitutes. Within the consumer-products industry, brands succeed
  in helping to build a competitive advantage, but even the pricing power of
  brands can be eroded with substitutes such as store-branded private-label
  offerings. In fact, some of these same store-brand private-label products are
  manufactured by the large consumer-products firms. The firms believe that if
  they can manufacture and package a lower-price alternative themselves, they
  would rather accept the marginal revenue from their lower-priced items than
  risk completely losing the sale to a private-label competitor. Verdict: High
  threat of substitutes.
  
  Degree of Rivalry. Consumers in this category enjoy a multitude of choices for
  everything from cleaning products to bath washes. While many consumers prefer
  certain brands, switching costs in this industry are quite low. It does not
  cost anything for a consumer to buy one brand of shampoo instead of another.
  This, along with a variety of other factors, including the forces we've
  already examined, makes the industry quite competitive. Verdict: High degree
  of rivalry.
  
  Examining an industry through the framework of Porter's five forces helps
  illustrate the different dynamics at work. It's not always clear-cut, either,
  so one wouldn't expect all of the firms in this industry to fall into one big
  bucket labeled wide moat or narrow moat. Instead, there are firms with
  distinct, long-term advantages and wide moats, like Procter & Gamble and
  Colgate, while others have advantages that we think may be less sustainable,
  such as Clorox and Kimberly-Clark.
  
  
  Getting Back to Moats
  Porter's framework makes scouring an industry for great investment ideas much
  easier. Understanding an industry helps us find the great businesses with
  economic moats that will withstand the inevitable economic, competitive, and
  random other challenges that often cripple weaker businesses.
  
  Once we have a collection of great businesses from which to choose, finding
  those that meet our criteria and deliver above-average returns on invested
  capital over the long term becomes even easier. (We will discuss returns on
  invested capital more in Lesson 305.)
  
  Generally speaking, we believe investors should steer clear of companies that
  have no moat (those with a Morningstar moat rating of "none") because they
  have very few, if any, competitive advantages and can't keep rivals from
  eating away at their profits. (Lots of these companies don't even have any
  profits.) For example, we don't think Delta Air Lines DAL, Albertson's ABS,
  and Goodyear Tire & Rubber GT have moats around their respective businesses.
  More than likely, we wouldn't want to hold a no-moat company for the long
  haul, so we probably wouldn't buy stock in one of these firms to begin with.
  
  Some people are shrewd enough to buy no-moat stocks on a dip, hold them for a
  short term, and make a profit. As long-term investors this isn't a game we
  like to play. We think the rewards are far better, and the risks much lower,
  for those who spend a little effort to find strong companies to hold for a
  long time.
  
  
  Types of Narrow Moats
  There are certainly gradations of moat width, and we here at Morningstar
  describe companies with milder competitive advantages as having "narrow"
  moats. From our point of view, far more companies have narrow moats than wide
  ones. Narrow-moat firms are, on average, of a much higher quality than no-moat
  companies. Generally, narrow-moat companies generate lower returns on invested
  capital than wide-moat companies but still have returns slightly above their
  cost of capital. (We will talk about return on invested capital and cost of
  capital extensively in coming lessons.) Narrow-moat companies typically come
  in two varieties:
  
  Firms with Eroding Moats. These companies have competitive advantages, but
  they are eroding due to a shifting industry landscape. This scenario is faced
  by some of the consumer-products companies, like those we just examined. For
  example, we consider both General Mills GIS and Kellogg K to be narrow-moat
  firms. The pricing power they once enjoyed is eroding as a result of increased
  competition and an ever-consolidating retail landscape that is increasing
  buyer power. The Baby Bells, such as SBC SBC and Verizon VZ, are another
  example; their economic moats are also slowly eroding. In future years, they
  won't enjoy the monopoly pricing power they once did because of the increased
  use of wireless phones and, of course, the Internet.
  
  Firms with Structural Industry Challenges. A company in this category
  dominates its peers, but resides in an industry where wide moats are nearly
  impossible to create. For example, in the airline industry, it's pretty much
  impossible to create pricing power, and even being a low-cost provider doesn't
  always bring stable profits because the industry itself is just too
  commodified. People tend to just book the cheapest fare, with little regard to
  brand. One of our favorite firms in the airline industry, Southwest Airlines
  LUV, is a good example of a narrow-moat firm that has a solid low-cost
  positioning, but still faces serious industry challenges, such as volatile
  fuel prices.
  
  
  Wide Moats
  All things equal, we'd choose a wide-moat company over one with a narrow-moat
  rating for the significant competitive advantages that should enable the
  wide-moat firm to earn more than its cost of capital for many years to come.
  
  Most wide-moat companies have some sort of structural advantage versus
  competitors. By "structural," we mean a fundamental advantage in the company's
  business model that wouldn't go away even if the current management team did.
  With a structural advantage, a company isn't dependent on having a great
  management team to remain profitable. To paraphrase Peter Lynch, these are
  companies that could turn a profit even with a monkey running them, and it's a
  good thing, because at some point that may happen.
  
  We hate to sound like a broken record here, but the four types of moats that
  we identified in the previous lesson are incredibly useful when thinking about
  structural advantages a company may or may not possess. Keep the four types of
  moats in mind:
    Low-Cost Producer or Economies of Scale
    High Switching Costs
    Network Effect
    Intangible Assets
  
  Wide Moats Versus Deep Moats
  With the concept of a wide moat firmly in place, it's also important to
  realize that the width of a firm's moat, or how broad and numerous its
  competitive advantages are, matters more than the moat's depth, or how
  impressive any individual advantage is. Discerning between width and depth can
  be difficult, however.
  First, it's absolutely critical to understand not only what an economic moat
  is, but also how it translates to above-average returns on capital. Many
  investors easily surmise the first point about moats--that a competitive
  advantage is required--but they miss the importance of the second point,
  above-average returns. If the business doesn't throw off attractive returns,
  then who cares if it has a competitive advantage? Autos and airlines are two
  businesses with some barriers to entry, but few new competitors are trying to
  crash the party in a race for single-digit ROEs or bankruptcy.
  Over the years, Warren Buffett has frequently referred to his desire to widen
  the moats of his companies, but it's rare to see him refer to a moat's depth.
  Buffett's frequent talk of moat width--and silence on moat depth--speaks
  volumes. Michael E. Porter has said, "Positions built on systems of activities
  are far more sustainable than those built on individual activities."
  Unfortunately, no company is going to tell you if it has a moat, much less
  whether that moat is of the wide or deep variety. If a firm has a competitive
  advantage, it behooves it to not tell you how its moat has been built. After
  all, you just might emulate it.
  Still, it can be worth investors' time to ponder whether the stocks they're
  invested in have one really fantastic competitive advantage that, while deep,
  may lack width, or if they're invested in firms with a series of advantages
  that can sustain above-average returns on capital over the long haul.
  Consider well-run giant conglomerates like General Electric GE or Citigroup C.
  Finance theory tells us that these decades-old firms should have seen their
  returns on capital dribble down to their cost of capital ages ago due to
  rivals competing away the excess returns. (We'll talk much more about returns
  on capital and cost of capital in coming lessons.) Yet, Citigroup's ROEs are
  still in the upper teens even in a bad year.
  Why haven't competitors captured these profits? Quite simply, these firms are
  pretty good at an awful lot of things. If Citigroup is hobbled by problems in
  its private banking unit or regulatory scandals on its trading desks, it can
  rely on its impressive credit card operations and retail banking business to
  carry the day. At GE, if new competition from cable hurts the NBC network or
  its insurance division posts lackluster returns, it can rely on a cadre of
  numerous other good businesses to pick up the slack. Like stacked plywood,
  each of these businesses is strong in its own right, but virtually
  indestructible together.
  The Bottom Line
  This and the preceding lesson have covered a lot of material about moats and
  the qualitative aspects of a company's positioning. Though this step in
  identifying attractive companies for investment is an important one, it is
  only the first step. In coming lessons in this book, we will show you how to
  quantitatively confirm that a company has a moat, as well as show you how to
  value stocks so that you don't blindly pay too much for a quality company.