In his 1996 letter to Berkshire Hathaway shareholders, Warren Buffett advised that investors should look to “purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, 10 and 20 years from now.” Executed consistently, and combined with a good dose of patience, this strategy can deliver quite satisfactory results.
It remains sound advice, but reliable companies are becoming harder to identify ahead of time due to rapid technological changes. Just consider the impact the likes of Facebook (US:FB), Uber and Airbnb have had on the traditional communication, transportation and hotel industries over the past 10 years.
Indeed, a recent paper in the Harvard Business Review studied the longevity of 30,000 US companies over a 50-year period and found that corporate life cycles are shrinking faster than in prior decades. More critically, the authors found that “the rise in mortality applies regardless of size, age, or sector”, and is largely driven by companies “failing to adapt to the growing complexity of their environment”.
Now, this may sound like an argument for investors to trade more frequently; however, the benefits of long-term investing haven’t diminished in the slightest. Compounding returns remains the key to long-term results and trading costs and capital gains taxes remain a drag on returns.
So, as long-term investors, how do we begin to adapt to this new reality?
One way is to spend less time worrying about a company’s size or geographic location and more time thinking about whether or not that company has durable competitive advantages, sometimes called ‘economic moats’ – a term coined by Buffett himself. If each company is a castle, the metaphor goes, capitalistic forces will try to knock it down if it is doing well. And the more successful a company is – high profit margins, high growth rates, or high returns on capital – the more it will attract the competitive hordes. Only those with wide and deep moats around their castles will survive and thrive.
With well-funded innovators coming out of Silicon Valley and elsewhere, it’s imperative to ask yourself these three questions before – as well as after – making a long-term investment.
1. ‘What would prevent someone with £1bn or even £10bn from replicating this company’s business model?’
If the profit opportunity exists, capital will try to find its way in. Some companies, however, are able to sustain high profit margins and returns despite the frequent threat of new competition.
Someone trying to replicate Diageo's (DGE) business, for example, would struggle to match the Johnnie Walker whisky brand value, estimated at over $4bn, which has a nearly 200-year head start on a new competitor. Even if the competitor wanted to try, the first batch of their own Scotch would take a decade to age properly before it could go head-to-head with the Johnnie Walker Black Label and above. And this is just one of Diageo’s product lines, saying nothing of the scale advantages that Diageo enjoys over its competitors.
2. ‘To what degree am I confident that the company will be engaged in roughly the same business in the next five or 10 years?’'
Becoming a good chess player is hard enough, but imagine if the number of pieces and squares continually changed. Such instability in the corporate world makes it increasingly difficult for management teams to reliably deliver high returns on invested capital for shareholders. As such, you want to focus your attention on businesses where technological disruption is minimal. It’s even better if the company benefits from the technological change that makes it cheaper or easier to run the business.
To illustrate, the odds that British American Tobacco (BATS) will be making, distributing and selling cigarettes in 2026 in much the same way it is today are quite high. Contrast this with a grocer such as Tesco, which will need to adapt to rapid changes in online shopping and delivery. At least in this aspect, British American Tobacco should have a far better chance of sustaining higher returns than Tesco over the next decade.
3. ‘Is the company’s competitive position getting stronger or weaker with time?’
Once you’ve identified the source of a company’s economic moat, you can start to determine if that advantage is getting stronger or weaker.
One of Facebook’s moat sources, for example, is that it benefits from a ‘network effect’. With the addition of new users and greater activity from current users, the Facebook network becomes more valuable to both the product’s customers and to the company itself. A long-term investor in Facebook, therefore, should pay attention to the number of new users and active users to gauge trends in the company’s moat strength.
Accounting and payroll specialist Sage (SGE) possesses a ‘switching cost’ moat source. To put it another way, the costs associated with switching from Sage’s software to a competitor’s offering – retraining employees on the new software, disruptions to core business operations, etc – probably outweigh the cost-savings offered by a lower sticker price. The company’s high contract renewal rate of 84 per cent, which was up from 83 per cent in the 2014 fiscal year, reflects this advantage. As a Sage investor, then, you’d want to keep an eye out for anything – good or bad – that affects companies’ incentives to keep Sage as their accounting and payroll software provider.
While these illustrative examples are larger companies, such advantages aren’t limited to blue-chips. Smaller companies can also possess durable economic moats and may even be nimbler in response to competitive changes than their bigger brethren.
In previous editions of this series, we’ve looked at US and UK shares, so let’s take a look at three smaller European companies with attractive business models that could be worth an investment at the right price.
Bakkafrost (OBX:BAKKA)
Country/Primary exchange: Faroe Islands/Oslo
Share price: NOK313.60 (£30.08)
Market cap: €1.7bn (£1.47bn)
Dividend yield: 3.3 per cent
Trailing PE: 19 times
Nestled in the remote north Atlantic, some 200 miles north-northwest of Scotland, the Faroe Islands enjoy ideal salmon farming conditions. The cold sea temperature, strong currents and pristine water quality, combined with inadequate spacing of the islands in the archipelago, provide local salmon farms with the ability to grow exceptionally large salmon (read: premium pricing) with less risk of disease spreading. In fact, the conditions are so good that the salmon do not need antibiotics, thus increasing the desirability of Faroe Island harvests from sushi chefs and other health-conscious consumers. Even if a competitor had the capital, they could not find similar geographic advantages possessed by the Faroe Island farmers. This in itself is attractive from an investment standpoint.
Even better, there are only three salmon farmers operating on the Faroes, down from well over 60 producers a few decades ago. Better still, Bakkafrost commands a 77 per cent market share of Faroe Island salmon production and each of the islands’ producers are vertically integrated, meaning they control the entire process from the first ingredients to delivery. Indeed, Bakkafrost has such a well-oiled logistics operation that it can get fish to Los Angeles within 72 hours following harvest.
Faroe salmon production is also relatively small in terms of global salmon production, resulting in a scarcity factor that contributes to Bakkafrost’s ability to charge premium prices. It smartly focuses on high-end restaurants and retail across the globe and it should be able to pass on higher costs as needed.
In all, the Faroe Islands salmon industry looks like a true rational oligopoly where there’s no room for new entrants and industry participants aren’t engaging in destructive price wars.
These advantages are evident in Bakkafrost’s high profit margins – gross margins are consistently around 60 per cent and operating margins have averaged just under 30 per cent across the last seven years. Some major risks to Bakkafrost’s business include natural disasters (disease, storms, etc) that could dramatically reduce Faroe Islands salmon production for a year or more, a major change in consumer tastes, and an inability to transport salmon long distances at a cost-effective price.
Still, given Bakkafrost’s numerous competitive advantages, the seemingly steady global demand for salmon, and the company’s generous dividend policy of paying out between 30 per cent and 50 per cent of adjusted earnings per share, Bakkafrost is definitely worth further research.
Tonnellerie Francois Freres SA (Fr:TFF)
Country/Primary exchange: France/Euronext Paris
Share price: €96.90 (£83.89)
Market cap: €525m
Dividend yield: 0.8 per cent
Trailing PE: 18.2 times
From my home in the US state of Ohio, I’m just a short drive from Kentucky, a state that produces 95 per cent of the world’s supply of bourbon whiskey. Even though bourbon production grew 170 per cent between 1999 and 2014, according to the Kentucky Distillers Association, the distilling process hasn’t changed much over the years. US law requires that, among other things, bourbon is manufactured using a grain mixture that is at least 51 per cent corn, aged in new charred oak barrels and aged for at least two years (to qualify as ‘straight’ Bourbon). In fact, at the Maker’s Mark distillery, two people still manually dip every bottle top in wax to achieve the brand’s iconic bottle look. Put simply, there’s not a lot of newfangled technology used in the process.
France-based cooperage, TFF, is a prime beneficiary of this old and proven system. Led by the fourth generation of the founding Francois family, TFF has a dominant position in the global barrel-making industry for wine, Scotch whisky, and increasingly for Bourbon whiskey. With a global market share above 25 per cent, TFF accounts for more than 30 per cent of the wine coopering market and 90 per cent of the independent market for Scotch whisky barrels.
A company intent on entering the coopering industry would encounter three formidable obstacles. First, there’s a steep learning curve in manufacturing wood barrels, especially to the quality level customers demand to ensure a consistent product. Second, and perhaps most important, is the massive trust required between a barrel maker and winemaker and distiller.
It’s a tall order to ask a winemaker or distiller to risk this year’s harvest or batch on your unproven barrel-making skills. The result is a switching cost advantage for TFF. Finally, TFF benefits from a location advantage. Shipping empty barrels long distances isn’t economically attractive, so cooperages need to be near the winery or distillery in addition to plentiful wood supplies. Securing these locations keeps shipping costs to a minimum and all but eliminates the threat of import competition.
One risk to this business is inventory management. Certain types of wines and whiskeys fall in and out of favour and the oak used for the barrels need to season for two or three years before they can be filled, making it challenging for the cooper to consistently match supply and demand. This limits returns on invested capital (ROIC), but TFF’s ROIC has nevertheless hovered between 10 and 12 per cent over the past 10 years – implying steady shareholder value creation – and operating margins have been consistently around 20 per cent.
Washtec AG (Ger: WSU)
Country/Primary exchange: Germany/Xetra
Share price: €41.70 (£35.95)
Market cap: €582m
Dividend yield: 4 per cent
Trailing PE: 21.2 times
Whether we like it or not, the number of cars on the road continues to increase. Figures from the Department for Transport in the UK, for example, showed 25.8m licensed cars were on the road in England in 2015 – up nearly 600,000 compared with 2014. We can find similar trends in the US and particularly in many emerging markets, where rising per capita incomes make car ownership an achievable goal for many new customers.
While these figures may be troubling from an environmental standpoint, it’s positive news for the automated car wash industry. The US Census Bureau, for example, estimates that the professional car washing industry generates about $6bn in revenue per year, with more than 8m cars washed per day. The industry also benefits from rising employment, which reduces the amount of spare time individuals have to wash their own cars.
This is all music to the ears of Germany-based Washtec AG, which is a global leader in car wash equipment and chemical sales. Washtec has a presence in 70 countries and has the world’s largest installed base of equipment with more than 30,000 customers. With car washing equipment needing replacement every seven to 10 years, along with regular maintenance and detergent sales, it can be a very predictable business indeed. We can find evidence of this strong business model in the company’s steady revenue growth and its stable gross margins, which hover just below 60 per cent.
Car washing naturally produces a lot of wastewater and the industry frequently gets negative attention during droughts. This is a risk, of course, but it is also an opportunity for Washtec’s water recycling solutions, which can help customers comply with local water use regulations and appeal to environmentally minded customers.
A potential upstart in the car wash equipment business would struggle to compete with Washtec’s lower cost of production (scale benefits), deep customer relationships, and proven quality and service capabilities. In the shoes of an independent or commercial car washing owner, taking a chance on a newcomer’s equipment could jeopardise your entire operation if it fails to work. There’s also no digital substitution for washing a car – old-fashioned water and detergent are still needed to clean off dirt and dust. All of these factors point to a steady durable competitive advantage for Washtec.
Bottom line
Each of these companies appears to have positive answers to the three questions we discussed earlier. Well-funded upstart competitors would find it challenging to enter the Faroe Islands salmon farming, oak barrel-making and car wash equipment businesses. To the extent possible, we can reasonably envision each of these businesses five or 10 years from now engaged in roughly similar activity to today. Finally, there isn’t a clear indication that any of their current competitive strengths are diminishing. As such, they are each worth your time for further research and, if you can get them for a good-to-fair price, they might be worth holding for quite a long time.
Todd Wenning, CFA is an equity analyst based in the US. The opinions stated here are his own and not those of his employer. He owns shares in Berkshire Hathaway
