32: Intel 4004 microchip: Moore's Law
This is surely the smallest object that we'll discuss. Okay, it's not exactly microscopic, but it will sit fairly comfortably on the end of my finger. Within it, however, its components - the bits that drive it and make it useful - definitely are microscopic.
Despite its tiny size, this little object has changed the world. Indeed, if we could rank objects by a formula that calculated the inverse relationship between lack of size and enormity of their impact, then this thing would win hands down. In the space of 30 years it changed the world and, in the process, created fabulous amounts of wealth. Now the object is so iconic that - despite being tiny, completely useless on its own and selling for just a few pence when it was first made - you would have to pay upwards of £100 to buy one on eBay (US:EBAY). And, incidentally, if you did buy one, then you would mount it in a show case, much like a lepidopterist would display a prized butterfly.
This little butterfly is actually a microprocessor, or a CPU, or a chip (they are all the same thing). Specifically - and this is important - it's the Intel 4004 chip and its significance is that, when it was launched in 1971, the 4004 was the first CPU to sit on a single chip of silicone. In other words, it was the first time that the power plant of a computer was miniaturised to such an extent that it became one tiny component.
Its size belied its power. The 4004 held about 2,300 transistors, effectively the gateways that microprocessors use to perform their binary logic, and was capable of processing more than 90,000 instructions per second - more than enough to power the desktop calculator for which the 4004 was first used.
Processing that number of instructions sounds impressive, although by the standards of today's microchips it's nothing. But that's the real significance of the 4004 - it was the start of a process, the start of Moore's Law.
Alright, in a way, that's not true. Gordon Moore, a co-founder of Intel (US:INTC) the California-based company that made the 4004, had noted back in 1965 that "the complexity (of integrated circuits) for minimum component costs has increased at a rate of roughly a factor of two per year. Certainly over the short term this rate can be expected to continue, if not to increase".
To spell it out, Mr Moore was making the prediction that the number of transistors on a microchip would double every year while simultaneously production costs would fall. Ten years later he scaled back that pace of increase to doubling every two years. But the relentless way in which transistor numbers rose while manufacturing costs fell led to the term 'Moore's Law' being coined in 1975 by a professor from California Institute of Technology.
True, Moore's Law is not a law of science as is, say, the first law of thermodynamics, yet its longevity is such that it seems like a constant of nature. To get a feel for its impact, compare the performance of the Intel 4004 with the microchips that Intel makes today. Whereas the 4004 held 2,300 transistors, Intel does not bother to say how many are held on its latest generation of Skylake chips. That's partly because the number has become too big for the mind to grasp. Suffice to say, however, that on the Haswell series chips that preceded Skylake, transistors numbered over 5bn. Simultaneously, the clock speed of chips - an indication of how fast they can process instructions - has risen from 740,000 cycles per second for the 4004 also to more than 5bn. Small wonder that, for example, today's Samsung Galaxy smartphone has far more computing power than a basement-full of humming main frames in the 1960s.
Apart from the way that Moore's Law has changed lives all over the planet, it has also changed investors' perception of what it takes to be a great growth stock. Shares in the most successful computer technology companies have been investments to die for. For example, in the 1990s, when Moore's Law had its greatest impact on the progress of computing, the share price of Intel, which Mr Moore co-founded with Andy Grove and Robert Noyce, rose 38 times from $1.08 to $41. Even that was nothing compared with the performance of Microsoft (US:MSFT), whose software piggybacked on the winning combination of Intel chips and IBM (IBM) PCs. Its share price soared during the decade from 60c to $59.
Sure, neither Intel nor Microsoft is the growth stock that it was, although both companies - and their share prices - are still doing nicely. Yet others have taken up the running; most obviously, that's Apple (US:AAPL), whose share price in the first decade of the 21st century rose by eight times from $3.67 to $30. Better still - and more recently - shares in UK-based Arm (ARM), whose chip designs dominate the market for smartphones, rose 20 times from 2008 to 2015 from 86p to £17.
Yet eventually all things - good or bad - come to an end, and Moore's Law will be no exception. The pressure created by exponential growth alone will see to that. It is one thing to double the number of switches on a microchip a few times when the starting number is a few thousand; quite another to repeat the trick when the starting figure is a few billion.
True, pundits have been forecasting the demise of Moore's Law for almost as long as it has been a 'law'. They haven't been right yet, but they will be. Lack of space on a silicon chip will see to that. When the gates on a transistor have become too small even to be seen through a powerful microscope and when the gaps between transistors are down to 14 billionths of a meter, then there is no more room - especially as, at this level, weird things start happening to the charges of electricity that move around the circuit.
However, there is a deeper truth about Moore's Law that will outlive the death of its electronic application. Essentially, Moore's Law is really a law of continuous improvement whose relevance is not just to the computer industry but to any industry you care to name. Because, in layman's language, Moore's Law is not really about cramming more transistors on to a microchip but about performing any process today better than it was done yesterday and doing it better still tomorrow. In that sense, it's not a law, but an imperative pursued by all great companies and - come to that - by all outstanding investors.
33: A can of WD-40 - barriers to entry
Almost every home in the UK - and, more important, in the US - has a can of WD-40 (WDFC) somewhere. Maybe it's under the kitchen sink; or in the garage or the garden shed. But somewhere there is that familiar blue-and-yellow can waiting for when it's needed.
And those needs are numerous. Britons and Americans love WD-40 because it can do so many things. Not just the obvious, such as lubricating locks, keeping garden tools rust-free and stopping moving parts from squeaking. It can also do esoteric jobs, such as removing chewing gum from just about anything, or - if the Daily Mail is to be believed - curing arthritis. Such ability and versatility in a product makes it a must-have and creates brand loyalty. You don't go into a DIY store and ask 'Where's the solvent remover?' You say, 'Where's the WD-40?'
Proof of the brand's strength is the company's financial record. Since 1967, when annual revenue first hit $1m, sales growth has compounded at 13 per cent a year, bringing income to $378m (£250m) in 2014-15. And in its latest year the group produced an 18 per cent operating return on its sales and a 23 per cent return on capital employed, which fed through to a 32 per cent return on equity.
Returns in that ballpark have been normal for the past 20 years. Yet the company has no patents or secret formulas to protect its products. It does nothing that would be beyond the likes of ExxonMobil, BP or DuPont. Even so, giants like those shy away. Why? The short answer is 'Barriers to entry'.
For business people and investors alike, barriers to entry are a vital - perhaps the vital - factor in assessing the merits of a company. Barriers to entry give a company the pricing power to ensure above-average returns on capital and the resilience to withstand and ward off attacks. They provide a competitive advantage that, once established, has the staying power that ensures excess returns year after year and, in the best cases, decade after decade.
Basically, barriers to entry fall under one of three categories:
■ Barriers of supply
■ Barriers of demand
■ Economies of scale
Supply barriers, as the words imply, restrict the supply of goods or services; or they permit a market-leading player to supply cheaper than its competitors. This means that customers find it hard to shop around - either they deal with that supplier, or they don't deal at all. Often, these barriers are linked to location - a company is successful because it just so happens to be based in the right place. The ultimate example might be the British Airways side of International Consolidated Airlines (IAG). Arguably, the cleverest thing that BA ever did was to have its antecedent companies based at Heathrow airport. Similarly, the quarry in the optimum location can always beat its rivals on price because their distance from, say, a prosperous region means their transport costs may be too high to bear.
Proprietary 'know-how' is also linked to supply barriers. Here a company has an edge - possibly related to its technology - that keeps competitors at bay. Quite likely this will stem from the long-term experience of dealing with complicated processes. Thus Vesuvius (VSVS), which supplies the consumables used in foundries, has erected a barrier because its ceramic components enable foundry operators to obtain higher yield.
Regulated monopolies - water suppliers or electricity distributors, for example - have natural barriers to supply. From investors' perspective, however, their shortcoming is that - as the name suggests - their ability to exploit their monopoly is restricted by law. Meanwhile, more companies benefit from regulations; either powerful regulations that, for example, award patents on the new drugs produced by pharmaceuticals companies, or legally enforceable rules - health and safety, for instance - which mean that providers have a ready market for their goods and services.
With demand barriers, customers can shop around but don't want to; they don't feel confident doing so or it's simply too much hassle. Barriers of demand are usually stronger than barriers of supply. Customers are captive, but they are content with that.
There are really just two barriers of demand:
■ Habit - where customers make frequent, necessary purchases almost automatically; tobacco companies and those supplying fast-moving consumer goods - the likes of Procter & Gamble (US: PG) - have these in spadefuls.
■ High switching costs - where the benefits for customers of changing from one product to another is not worth the hassle. For suppliers of software and financial services, this barrier is the highest.
However, demand barriers are strongest when they combine with some form of economy of scale, which is what WD-40 is all about. In order to compete with WD-40, a rival would have to spend huge amounts on distribution and marketing, and price its product below WD-40. But the price differential would be meaningless to consumers. After all, a can of WD-40 costs £5.99, so a 10 per cent discount for a me-too product will hardly tempt shoppers. It would, however, make it all the harder for the competitor to make money, especially as its fixed costs would be spread over a sales base that grows painfully slowly (after all, loyal customers can go many years before they buy a new can of WD-40). True, the effort could make serious inroads into WD-40's profits. But because WD-40 spreads its own fixed costs over far more sales than its theoretical rival, it would always be in a position to make the struggle even nastier for the newcomer.
So for those with the financial strength to hurt WD-40, the prize is not worth the struggle; while those for whom the rewards would be meaningful lack the muscle. In short, the ideal barrier to entry is erected in a niche market that is stable, is unlikely to go out of fashion, won't be subject to technological upheaval and where demand will be reliable. Simple really.
