Peter Thiel once said, “Competition is overrated. In practice, it is quite destructive and should be avoided wherever possible. Much better than fighting for scraps in existing markets is to create and own new ones.”
Research shows that 92.9% of businesses survived their first year in the UK. Yet, from 2007 to 2020, the survival rate dropped to 38.4%.
In the United States, only 31% of companies started in 1998 were still standing by 2005.
This is due to the brutal nature of capitalism.
Given this reality, we’re strong advocates for investing in near-monopolies.
Buffett highlighted that having a moat is crucial for investors because it provides a level of protection and stability.
“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.” Warren Buffet
Our view is that only a few companies that have a dominant market share can deliver true growth and value, and those are the ones worth investing in.
Have you heard the saying, “Buy a monopoly if you can’t buy a duopoly? And if you can’t buy a duopoly settle for an oligopoly”? The Myth of Capitalism.
Warren Buffet is one of the greatest investors, one of his investment philosophies is to buy a business where there is no competition.
A business that has pricing power and a moat to protect against competition such that it can preserve a high return on capital.
One of the things that distinguishes a great business from the rest is its ability to convert earnings into free cash flow.
This is a crucial metric that should be evaluated alongside how effectively capital is allocated and reinvested to keep the company competitive.
Notably, Amazon.com spent a whopping $73.2 billion on R&D in 2022, which is the highest among its peers, followed by Alphabet, Meta, Apple, Microsoft and Nvidia.
These are some of the best companies in the world.
Since all of those businesses above convert most of their earnings into free cash flow that will allow them to aggressively invest in R&D or acquire businesses to stay ahead of the curve.
They also have a great brand presence and reputation which provide a significant intangible value.
However, companies that spend heavily on R&D have an inherent flaw in their competitive advantage that will always put their long-term economics at risk.
Therefore the R&D spending has to be manageable as some of it will not come to fruition.
Buffet himself prefers the R&D expense to be less than 10% of total capital expenditure.
The Secret Sauce of Near-Monopoly Investing
We prefer companies with strong market shares in growing markets that are innovative and disruptive.
For example, Alphabet controls 93.69% of the UK search market.
The company has also been efficient in scaling other businesses atop which additional innovations can be built.
For example, they managed to get into the Cloud service, video streaming (YouTube), autonomous taxi driving (Waymo), artificial intelligence (Deepmind), Android, hardware, maps and other areas we use daily.
In addition, Alphabet has a high switching cost, and does have intangible assets, such as a strong brand, network effects and also has cost advantages. That’s why we invested in Alphabet a few years ago.
Margins and expenditures matter too. Companies with a gross profit margin of 40% or more is a good sign whereas anything below 20% is a poor indicator and means it is a fiercely competitive industry.
For instance, if you are investing in a biotech company, you will likely focus more on R&D, whereas tech companies tend to spend more on sales, general, and administrative expenses (SGA).
Since gross profit excludes a significant portion of their expenses, focusing on gross profit does not capture the entire picture. Operating profit will allow you to assess the business more accurately.
Similarly, firms spending less than 30% on selling, general, and administrative expenses are generally on solid footings. However, if a company has over 80% in SGA that indicates the company has no moat.
Ideally, their capital expenditure should be under 50%. If it’s less than 25%, even better. On the flip side, over 75% can signal a lack of a protective moat.
Companies with a robust competitive edge often don’t deal in preferred stock. Such businesses also tend to buy back their shares, holding them as treasury stocks. This practice boosts the company’s return on shareholders’ equity.
A high return on shareholders’ equity is a sign of a durable competitive advantage. However, make sure the high returns on equity are not generated by financial engineering or artificially inflated returns.
Depreciation is the real cost of business and companies with a durable competitive advantage have low depreciation costs and minimal interest expenses suggesting a strong competitive advantage.
For example, a company with a depreciation rate preferably under 10% is a sign that it doesn’t need a lot of capital expenditure assets to maintain its competitive advantage.
Most capital investments other than land are depreciated.
Accountants attempt to spread the cost of the expenditure over the useful life of the item.
Companies sometimes can artificially boost profits with a variety of accounting methods, including understating expenses and treating operating costs as capital expenditure.
For example, think about depreciation. If a company can depreciate an asset for 4 years vs the same asset for 8 years that will make a significant difference in net profit.
Always watch how the company depreciates the asset.
Additionally, in competitive industries, some attempt to gain an advantage by offering better credit terms, causing an increase in sales and receivables.
But companies that constantly show a lower percentage of debtors to gross sales than their competitors usually have some kind of competitive advantage.
Focus on GAAP earnings, as non-GAAP earnings add back employees’ compensation so the accounting treatment is more accurate.
One of the most common adjustments made to EBITDA is adding back stock-based compensation, as if paying employees wasn’’t a real cost of doing business.
Valuing a company on non-GAAP metrics obviously inflates the stock price more than valuing it under GAAP metrics would allow.
The difference between cash accounting and accrual accounting is revenue in cash accounting is reported when it is received and expenses when it is paid.
However, with accrual accounting revenue is reported when it’s earned and expenses when they are incurred which could be misleading.
Therefore, the focus should be on the cash flow statement.
Lastly, behind great businesses are visionary founders. It all boils down to this point.
Does management have unquestionable integrity and a long-term vision for the business?
Their rationality and expertise in capital allocation gives their firms a competitive edge.
It is the goal of the YFS Intelligent Wealth Fund to invest in a handful of companies that exhibit monopolistic characteristics.
However, even dominant companies can become complacent, resorting to rent-seeking behaviors, which are lazy habits.
Companies turn to taking advantage of customers rather than innovating and providing better services and that isn’t good for business.
We invest in companies that offer excellent benefits to their customers. To achieve it, economies of scale are crucial.
It allows the company to drive down costs and pass those savings on to its customers therefore it’s a win:win not a win:lose for customers.
In the long run, equities offer the best returns, so reducing volatility for its own sake is a strategy that does not deliver the best results.
As Jeremy Siegel said, “You have never lost money in stocks over any 20-year period, but you have wiped out half your portfolio in bonds (after inflation). So which is the riskier asset?
The world is rapidly changing and the advancement of technology is providing significant opportunities for investors.
The YFS Intelligent Wealth Fund is well-positioned to enable investors to participate in the new wave of innovation.
You have to resist making an unwise investment just because it could enable you to catch up with the indices or the competition.
Don’t let your inside fall to fear, greed or avarice as they can open the gate and let the enemy in.
Acknowledging what you don’t know is the dawning of wisdom. There is a power in knowing what you don’t know.
Think like a scientist not to own a microscope but to seek the truth as in a changing world, you have to be willing and able to change your mind and avoid confirmation bias or following the crowd.
It’s important to remember that only 0.1% of the stocks in the stock market created $17.6 trillion in wealth. Therefore, the aim is to hold a few extraordinary businesses for the long term.
Awet Ghirmay, Head of Investment Research
If you want to learn more about this topic, please find the link here.
More information about our fund can be found here: Hargreaves Lansdown or AJ Bell
Risk warnings
The value of investments and the income derived from them may fall as well as rise. You may not get back what you invest. This communication is for general information only and is not intended to be individual advice. You are recommended to seek competent professional advice before taking any action. All statements concerning the tax treatment of products and their benefits are based on our understanding of current tax law and HM Revenue and Customs practice. Levels and bases of tax relief are subject to change. This blog is based on my own observations and opinions.
