How to Recognize Wide-Moat Firms
by Pat Dorsey, CFA | 02-16-05 | 06:00 AM
What gives a company a wide economic moat? I get this question all the time, and it bears some discussion, since analyzing moats and thinking about competitive advantage is at the core of what we do at Morningstar.
People often think that analyzing moats is as simple as looking for strong historical profitability. Ah, if only it were that easy. In truth, history is an imperfect guide, since the value a company will create for shareholders is dependent on how well it fends off competition in the future. High returns on capital attract competitors, and those great historical numbers will fade fast if a firm doesn't have a strong competitive advantage. Oftentimes, that competitive advantage isn't obvious--you have to do some digging into the firm's business model to figure it out.
Let me walk you through four types of companies to show you how quantitative analysis meshes with more-subjective qualitative analysis in deciding the strength of a company's competitive advantage.
No-Brainers
First are the "no-brainer" firms, with strong historical returns on capital and a business model chock-full of "moaty" characteristics. These are the firms whose businesses approach that lovely nirvana of minimal capital investment and lots of cash generation. Think about Moody's MCO or eBay EBAY--great profitability metrics in the past, and competitive positions strong enough to make it likely that they'll be just as profitable in the future. Moody's is protected by a strong brand and government regulations, and eBay has a massive liquidity pool of buyers and sellers that would be very hard to replicate. Anheuser-Busch BUD, with its massive--and exclusive--distribution network would also be in this category, as would a classic blue-chip like American Express AXP.
Firms with Less-Obvious Advantages
Second, there are firms that have posted great historical metrics, but which have less-obvious competitive advantages. In other words, it's easy to see how well they've done, but a bit tougher to figure out why or how they'll continue to generate excess economic returns. Expeditors International EXPD and Weight Watchers WTW are good examples of this. Both have tremendous records of generating gobs of free cash flow and kicking out high returns on capital, but neither freight forwarding nor weight-loss management seem like intuitively wide-moat businesses.
If you dig into the two firms, however, you discover that Expeditors has a global network of offices and an incentive-based company culture that would be very tough to replicate. As for Weight Watchers, there's a strong brand and a flexible approach to weight loss--essentially, the firm is little more than an organized support group, since it can modify its content based on the latest scientific findings. It would be tough for a rival to compete with such an all-encompassing approach to weight loss. As you can see, the moats for Expeditors and Weight Watchers are more subtle than those for Moody's or eBay, but they're definitely evident once you do some qualitative analysis of the firms' business models.
Stericycle SRCL would be another good example in this category. As with freight forwarding and weight-loss management, medical waste disposal doesn't sound too moaty. You would need disposal facilities, a fleet of trucks--things that suck up lots of capital and which could depress returns on invested capital. But it turns out that it's really tough to get new permits for waste-treatment facilities, which limits competition, and network economies similar to those of a UPS UPS can yield high incremental margins as the firm increases the number of customers served by each collection site. The result is a business with solid returns on capital -- about 12% including goodwill and abut 30% without goodwill -- that looks pretty sustainable to us.
"Watch Your Back" Firms
Third, we have what I call "watch your back" firms, which have fabulous historical returns on capital, but are vulnerable to new competitive threats. Lots of technology firms fall into this category--remember Borland BORL (Quattro Pro), 3dfx (graphics chips), or all the firms that made pagers back in the day? All were very profitable businesses that were also very susceptible to competition or technological change.
Most retailers also fall into this category, since most retail "concepts" either get copied or go out of style. A couple of tech companies that we currently rate as having narrow moats-- Garmin GRMN and Zebra ZBRA--are also good examples. Garmin is a leader in global positioning devices, both for aircraft and for personal use. It's a solid, high-growth business with 40%-plus returns on capital, but we think that--eventually--there's not much stopping a bigger competitor from investing some capital, building a better mousetrap, and eating away at Garmin's profits. It doesn't look like this will happen any time soon, but Garmin will need to stay on its toes to keep ahead of the competition.
Zebra, which makes bar-code and plastic ID printers, also fits the bill. Right now it has solid market share and great returns on capital, but the advent of a new inventory-tracking technology called RFID could give new competitors a wedge to enter the business. Like Garmin, this is a great business, but one that's still vulnerable to competitive threats over time.
Tough Calls
Finally, there are the really tough calls--companies that have not yet posted great returns on capital, but that seem to have lots of wide-moat characteristics. I'd point to document-storage firm Iron Mountain IRM as a great example. Operating margins are solid in the mid- to high teens, but the firm has been plowing so much capital into its business that returns on invested capital are pretty mediocre in the midsingle digits. Moreover, it has only recently started generating free cash flow again, after a long dry spell in the 1990s when it was investing heavily.
However, when you consider that customers have to pay a fee equivalent to nearly a year's rent if they want to remove a box, some switching costs become evident. A competitor would have to offer some big discounts to overcome this cost, and since document-storage facilities become profitable only after they're 50% full, that would-be competitor would have to be willing to lose money for quite some time--a substantial barrier to entry. Also, since storage costs are a minuscule part of most companies' budgets, Iron Mountain has pricing power--gross margins have been steadily rising for almost a decade. Finally, it costs a lot less to maintain a storage warehouse than it does to build a new one, so free cash flow should improve considerably once Iron Mountain moves out of its growth phase.
All these sound like pretty moaty characteristics to me, but assuming that Iron Mountain has a wide economic moat is still a bit of a leap of faith, since it hasn't yet put up the numbers.
That's the point, though--investing is a mix of quantitative and qualitative analysis. Usually, the first tells you where a company has been, and the second helps you figure out where it might be going.
A version of this column originally appeared 3/17/04.
Pat Dorsey, CFA, is director of stock analysis for Morningstar. He can be reached at patrick_dorsey@morningstar.com.
When Hedge Funds Attack
By Will Swarts Published: March 2, 2005
MILLIONAIRES AND BILLIONAIRES ARE rarely seen as the natural allies of the little guy. But ordinary investors who own shares in sagging companies sometimes see their fortunes linked to hedge-fund managers whose annual salaries can reach into eight figures.
Activist fund mangers who control millions or billions of dollars can be an individual investor's best friends when they agitate for change or improved performance. And managers of other funds that short stocks can sometimes provide much-needed warning signs that a company is headed for trouble. If you know where to look, your fellow shareholders can be a big help, doing the heavy lifting you can't.
Unlike mutual funds, many players in the $1 trillion hedge fund industry are secretive — some decline to reveal their holdings even to their investors, who often must plunk down a $1 million minimum to get into the fund, then pay 1% annual management fees, as well as 20% of annual profits. But when a money manager with strong opinions — and the financial clout to back them up — weighs in, it can be a boost all around. Ask shareholders of Kmart (KMRT), who saw the stock climb from $15 in May 2003, when the company emerged from bankruptcy protection under the leadership of hedge fund manager Edward Lampert, to close at $99.15 today.
More recently, Highfields Capital Management last month made a $3.25 billion, or $17 a share, unsolicited bid for electronics retailer Circuit City Stores (CC), which, even after the stock's subsequent runup, offers a 6.5% premium to its current price of $15.90.
Greater numbers of funds are willing to throw their weight around, and will agitate for change even before they own 5% of a company, the threshold at which they must notify the Securities and Exchange Commission of "beneficial ownership," which makes their stake part of the public record. George Van, chairman of Van Hedge Fund Advisors, a hedge fund investing and consulting firm in Nashville, Tenn., says this doesn't always happen with genteel diplomacy.
"What I've seen is very straightforward, with a hostile edge," he says. "It may be constructive, but the approach can be pretty hard. That letter to Circuit City — they were pretty rough."
"Obviously, you want an improvement in operations, and it affects all shareholders equally," says Daniel Loeb, chief executive of Third Point, a New York hedge fund known for its sometimes brutal letters (see here and here) to officers of companies it hopes to turn around. "We're trying to get management to do what the board should be getting them to do — to perform their job function and maximize value for shareholders."
Though they haven't seen it yet, shareholders in troubled budget airline Independence Air (FLYI) could see their stakes double if the partners of East Texas Capital get their way. Since hitting a Nov. 12 low of $1.04 a share, the beleaguered carrier has rebounded slightly, closing at $1.45 on Wednesday, though it's still well off its 52-week high of $7.93, which it soared to, briefly, on April 12.
The small but scrappy hedge fund, based in Center Valley, Pa., rarely has more than $20 million under management. But what it lacks in size it makes up for in gumption. Last Wednesday it urged Chairman Kerry Skeen to hire a financial adviser to find a buyer for the Dulles, Va.-based budget carrier. Last November, the Boston hedge fund Par Capital Management, which owns about 10% of the airline, wrote to the carrier and urged it to pursue a sale or secure regional flying contracts with larger airlines to keep from folding its tent.
East Texas's pitch was somewhat different from Loeb's high-and-inside fastballs — East Texas has about 1% of Independence Air's shares, and not nearly enough money to force the issue. Also, the hedge fund's managers actually like the company, which just completed a particularly difficult restructuring at a time when the fortunes of many carriers are effectively grounded.
"Your recent restructuring is laudable and our principals are impressed by your product and your employees," the letter said. "However, especially in view of the extremely difficult operating environment for airline companies, it is [our] desire that you quickly find a merger partner that can assist you in better utilizing the assets you manage and maximizing the return for your shareholders."
Bob Miller, who handles real-estate investments for the partnership, said East Texas — named for a Pennsylvania village a few miles west of Allentown — hasn't heard back from FLYI management, and doesn't expect to any time soon.
"It's our belief that the stock is currently trading at 40% to 50% of book value — I think that the stock is just grossly undervalued at this time," he says. "We've had to take these stances reluctantly. The management is really encumbered with their restructuring, and I know they're busy. Saving the company is one thing, increasing shareholder value is another."
Independence Air spokesman Rick DeLisi said the airline hadn't commented on either letter and declined to discuss any potential announcements in the future.
Short sellers don't bother with tough love. These funds borrow stock, usually from a big investment bank, and pay interest on it, hoping that it will drop in price. They then sell it back, and pocket the difference. Web sites such as SmartMoney.com display the short interest on particular companies, and investors can use those numbers to see if more big investors are betting against a company.
James Chanos, a well-known short seller, was the first investor to raise questions about Enron, sparking a line of inquiry that led to the unraveling of the Houston energy trading company's Byzantine — and illegal — financial structures.
"The activist shareholder and the guy who shorts a stock are sometimes selling to each other," says George Lucaci, managing director of Channel Capital, a New York firm that owns HedgeFund.net, a Web site for hedge fund news and information. "They add a lot of liquidity, and I believe it has also increased volatility."
While short selling and shareholder activism might each — or in combination — make a stock's price move more than normally, Lucaci says the end result can make companies better. "It has often woken management up," he says. "They realize they have to be more aware of what they are doing, and why."
High time to regulate Hedge funds
Hedge funds accused of fraud
Restraining order issued against firm
By Alexandra Navarro Clifton
Business Writer
Posted March 4 2005
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A West Palm Beach hedge firm and its advisers lost nearly all of the $81 million it raised from at least 250 investors, including some from Palm Beach County, according to an emergency restraining order issued Thursday by a federal judge.
KL Group LLC and a number of its funds, including KL Financial Group Florida LLC, stopped trading and closed its offices earlier this week after the Securities and Exchange Commission and FBI officials began investigating the firm. The SEC filed a lawsuit against the fund claiming it defrauded investors, and U.S. District Court Judge Kenneth Ryskamp of West Palm Beach issued the temporary order Thursday.
The complaint also named the funds' principals Won Sok Lee, 34, of Singer Island, John Kim of Jupiter and Yung Bae Kim, 34, of Irvine, Calif., as well as a number of related hedge funds run by one or more of the defendants. The SEC does not know where Lee and Yung Bae Kim are, according to the complaint.
At his Jupiter home, a woman who answered the telephone said John Kim "had nothing to say."
The complaint alleges that since 1999, when the fund was founded in California, it raised more than $81 million and claimed high returns by trading in aggressive growth stocks. But investors were sent false statements on at least one hedge fund that was actually suffering massive losses, and only about $11 million of the original $81 million remains, according to the complaint.
Boca Raton attorney Gary Klein represents 30 investors who collectively lost about $30 million. Klein said many of his clients lost all or nearly all of their retirement investments and thinks losses will ultimately be much higher.
"It's a good start, but I think the numbers are low," said Klein. "I'm sure the next couple of months will reveal higher losses."
Hedge funds and their managers are not regulated and offer high-risk investments in exchange for high returns. They're aimed at wealthy and sophisticated investors.
According to the complaint, KL Financial documents claimed the fund had annualized returns of up to 150 percent. The defendants named in the complaint also earned substantial fees of 20 percent of the funds' reported profits.
David Nelson, the SEC regional director in Miami said the next step takes the case on two tracks. The SEC will continue to pursue a lawsuit against KL Financial and the defendants while court-appointed receiver Guy Lewis takes over the company and begins an internal investigation. Lewis, a former U.S. attorney in Miami, may find higher losses, additional assets or identify additional defendants, said Nelson.
"This was a company based on lies," said Nelson. "It's not the biggest fraud I've seen in my 12 years, but it's definitely in the top 5."
Alex Clifton can be reached at anclifton@sun-sentinel.com or 561-243-6529.
