Economic Moats and the HR Practitioner

Introduction

Businesses are grown from taking actions on a business opportunity. That business opportunity could have started out as an identified gap or need or emerging event which the entreprenuer took upon himself as a mission to fulfill. It is his or her way of making a difference in the world. It is the point where his personal values shaped the hopes he had for contributing to society.

To sustain his or her efforts in the pursue of that mission, he or she know that it is essential to monetise that business opportunity. The monetisation efforts consist of 2 components :(a) creating the revenue streams – identify what people want and putting a price on it (b) making the cashflow automatic and consistent.

His first task is to ensure that his business plans have the greatest chance of taking off. The chances will be greatest if he could:

  • Identify what is critical to the solution that he is providing.
  • Play in an area where there is no competitors.
  • Build a first entrant advantage.
  • Minimise the loss of his own capital.

His aims are first to attain consistent earnings and second to grow earnings overtime. The consistent earnings will cover help recurring business expenditures and ensure the business stays healthy, while the growth in earnings mean that the availability of retained earnings to expand the business.

Meaning of Economic Moat

An economic moat as something that allows a business owner to continue to work on and grow his business without him having to struggle to try and control challenges that are not within his control or reach or influence. It is what differentiates an excellent business and a mediocre business.

Reasons for Understanding and Appreciating a Business’ Economic Moat

Once a person is working inside a business, it is easier to do a business analysis, assess and rate whether a business have an economic moat.

In Philip Fisher’s speech in Stanford Business School to his 1961 students, he said : “A typical company gets comfortable, does not like change, but has competitors down the street who are thinking of something new that is going to obsolete the status quo. Your company has got to be the one running ahead of the change. One way to recognize proper management is to look for their response to that change. The importance of that difference may be translatable into huge market share or even survival.”

For an investor who buys moats instead of creating one, the existence of a moat has special value since they can sometimes survive financially even if management talent does not deliver as expected or if they leave the business.

The following are the reasons why the HR practitioner should strive to understand and appreciate a business’ economic moat or lack of it.

You work for the business. If it cannot ride through economic storms, you not only have to lay off employees, but you will also lose your job. If the business does well, it will have money for salary increments, bonuses and promotions. Remember this – You are just a business cost. Whenever the Board or Managing Director makes a business decision, your livelihood will be the furthest from their minds.

The role of the human resources function is to attract, retain and develop talents for the business. If the business does not have enough financial resources:

  • You will not be able to pay everyone at market rate. This affects salary offers to potential hires, distribution of salary increments and bonuses, and becomes a push factor for employees to join a competitor. The business will face the risk of vacancies that go unfilled for a period of time. Candidates that took jobs at the company are probably using it as a stepping stone while awaiting for a better offer elsewhere.
  • To enhance existing employee benefits, you have to depend on yourself to design non-monetary benefits. You have to explore and tap on government funding for various programs.
  • The HR department will probably be understaffed.
  • You cannot afford the services a lawyer to craft your employment contract, your sales incentive plan or vet your various HR forms and Employee Handbook. You have to roll up your sleeves to do it yourself.
  • You cannot afford a consultant to create your internal salary structure and design your compensation programs. The company probably cannot afford to purchase compensation data from compensation specialists such as Mercer, Tower Watson, Hewitt, Hays and so on.
  • The implementation of operational and financial system will take precedence over the implementation of a HR system. The most the company will pay for is an off the shelf payroll system. Imagine you will be managing all types of leave using spreadsheets. The HR function will be more transaction driven rather than strategy driven.
  • You will find yourself trying to save costs on the small items that may meant a lot to employees, such as pantry supplies.

These are some examples.

Examples of Economic Moats

Morning Star identified 4 types of moats:

  • Creating real or perceived product differentiation
  • Driving costs down and being a low-cost leader
  • Locking in customers by creating high switching costs
  • Locking out competitors by creating high barriers to entry or high barriers to success

Stockpedia elaborated on these 4 types:

  1. Intangible Assets
  • Brands – business identities that have a positive recall in the minds of consumers
  • Patents – exclusive rights over a product/service granted by the government to the inventor for a limited period.
  • Regulatory approvals – licenses granted to business by the government creating barriers to entry for others
Switching Costs When a business creates high switching costs for its customers, it automatically creates a moat e.g. Banks, Credit Cards, etc.
Network Effects
  1. When a business creates a product/service that is used by everybody else, the network effect of usage of that product/service creates a high switching cost and therefore a high moat for the business e.g. pdf format for document interchange developed by Adobe Inc.
Cost Advantages
  • Cheaper Processes – Businesses that are able to do the same job using cheaper processes develop a cost advantage and hence a moat.
  • Location – Businesses that have a location advantage develop either a cost or a revenue advantage or both, and thereby develop a moat.
  1. Greater Scale or Niche

 

  • Distribution Networks – A business that can influence the distribution channel to give preference for selling its products has a natural moat over its competition.
  • Manufacturing Scale – A business can develop a moat by using economies of production scale to derive cost advantages
  • Niche Markets – A business can also develop a moat by targeting its products and services towards niche markets.

What Is Not an Economic Moat

Pat Dorsey, author of the book ” The Little Book That Builds Wealth:The Knock Out Formula For Finding Great Investments” identified some mistaken moats:

  • Size / Dominant Market Share: High market share does not give a firm a moat. In fact, market share may be irrelevant – bigger is not necessarily better.
  • Technology: What one smart engineer can invent, another can improve upon. (Exception: Creating a standard that’s widely adopted.)
  • Easily-replicable cost advantages (lean manufacturing, outsourcing.)
  • Hot Products: Can generate high returns on capital for a short period of time, but sustainable returns are what make a moat.

Nine Questions

In their book “Buffettology,” Mary Buffett and David Clark have a list of 9 questions to determine if a business is truly an excellent one:

  • Does the business have an identifiable consumer monopoly?
  • Are the earnings of the company strong and showing an upward trend?
  • Is the company conservatively financed?
  • Does the business consistently earn a high rate of return on shareholders’ equity.
  • Does the business get to retain its earning?
  • How much does the business have to spend on maintaining current operations?
  • Is the business free to reinvest retained earnings in new business opportunities, expansion of operations, or share repurchases? How good a job does the management do at this?
  • Is the company free to adjust prices to inflation?
  • Will the value added by retained earnings increase the market value of the company?

Twelve Questions

If you are interested about doing business analysis on your employer’s business, in his book “Common Stocks and Uncommon Profits,” Philip Arthur Fisher listed 15 key questions that you can think about:

  • Does the company have products or services with sufficient market potential to make possible a sizeable increase in sales for at least several years?
  • Does the management have a determination to continue to develop products or processes that will still further increase total sales potentials when the growth potentials of currently attractive product lines have largely been exploited?
  • How effective are the company’s research and development efforts in relation to its size?
  • Does the company have an above average sales organization?
  • Does the company have a worthwhile profit margin?
  • What is the company doing to maintain or improve profit margins?
  • Does the company have outstanding labour and personnel relations?
  • Does the company have outstanding executive relations?
  • Does the company have depth to its management?
  • How good are the company’s cost analysis and accounting controls?
  • Are there other aspects of the business, somewhat peculiar to the industry involved, which will give the investor important clues as to how outstanding the company may be in relation to its competition?
  • Does the company have a short-range or a long-range outlook in regard to profits?
  • In the foreseeable future, will the growth of the company require sufficient equity financing so that the larger number of shares then outstanding will largely cancel the existing stockholders’ benefit from this anticipated growth?
  • Does the management talk freely to investors about its affairs when things are going well, but ‘clam up’ when troubles and disappointments occur?
  • Does the company have a management of unquestionable integrity?

Concluding Remarks

This article is not an exhaustive research on economic moats nor an attempt to provide a framework for business analysis. If you are a Human Resource Practitioner and what I described above is happening to you, you might want to take steps to understand how your employer’s business works and think about how it impacts you and your job.

REFERENCES

The Focus Investing Series – Parts 1, 2 and 3 written by Richard M, Rockwood

http://www.focusinvestor.com/FocusInvestorSeriesPart1.pdf

http://www.focusinvestor.com/FocusSeriesPart2.pdf

http://www.focusinvestor.com/FocusSeriesPart3.pdf

How to Build A Moat

http://news.morningstar.com/classroom2/course.asp?docId=144752&page=2&CN=

The Morningstar Economic Moat Rating

http://www.hsbcnet.com/gbm/attachments/products-services/trading-sales/structured-products/united-states/morningstar-economic-moat.pdf

Durable Competitive Advantages (Pat Dorsey)

http://zenway.com/d/sites/default/files/Moats_CFA_Roch.pdf

Charlie Munger on Moats

http://25iq.com/2012/12/06/charlie-munger-on-moats-first-of-the-four-essential-filters/

 

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