- Richard Daly
For value investors, one of the holy grails has been finding companies with wide competitive moats. These are investments with common characteristics – return on capital higher than the cost of capital, high margins, steady revenue/earnings growth, and dominant market share. These companies can be tremendous long-term investment opportunities. As an investor becomes more experienced in research and identifying such companies, it becomes apparent that such investment opportunities are often clumped in industries with a penchant for individual-wide moat investments. Much like our hunter-gatherer ancestors learned, it isn't just the individual investment but the industry/market that can lead to long-term outperformance. This is an ecosystem that creates an environment which - by its very nature - is conducive to deep competitive advantages. There is, of course, no hard and fast rule, but over time at Nintai, we've identified several critical aspects within specific industries that lead to high percentages of investment opportunities.
Asset Light and Capital Light: Generally, industries and their companies that require high capital infusions, are asset-heavy, and have significant organizational needs (such as unfunded pensions for tens of thousands of former employees) and complex infrastructures (large manufacturing plants). They also have lower gross and net margins, lower free cash flow, and significant capital requirements. An example of this is large legacy manufacturing industries on which the great American middle class was created – steel, automobiles, etc. During the mid-20th century, these companies were able to achieve significant competitive advantages against other global competitors. But much like England in the early-20th century, competition in Asia slowly ate into profits and provided much cheaper labor and operating costs. The steel and automobile industry simply couldn't keep up with the demands for expensive pensions, new capital improvements, or new technologies that increased operating efficiencies. That doesn't mean there aren't some gems in such industries. Companies such as Fastenal (FAST) or Graco (GGG) operate in traditional manufacturing yet achieve outstanding results with high return on capital and equity while maintaining extremely low debt margins.
In the last several decades, new industries have developed in the United States – technology, data & informatics, pharmaceuticals, etc. – that don't require significant capital injections, don't use sizeable unionized labor forces, and don't have many assets on the balance sheet. These companies came about in the early 2000s and became known as "asset-light" companies. Even large businesses like Schering-Plough (now Merck & Co.) were famous for shedding assets, moving employees from pensions to 401(k)s, and outsourcing core functions like research and development. These actions completely changed the business model, driving returns on capital and equity higher, increasing gross and net margins, and making these companies look much less like traditional research and manufacturing companies and more a modern marketing healthcare company. Some examples of industries with asset-light models include technology (software, informatics - meaning the integration and usage of data), health care (contract research organizations - CROs), and financial services (credit card processing, asset management)
Ease of Competitive Dominance: In these asset-light industries, the ability to achieve competitive advantages is easier than others. Please note I didn't say they are easy; they are easier than others. These companies are run by focused, driven management teams that make dominance seem easy. But looks can be curiously deceptive. It can be easier to develop a competitive moat because the market conditions, product/service offerings, and raw materials might be subject to easier dominance. For instance, there are very few areas in the automobile industry where a company might capture significant competitive advantages. There is little need or ability to acquire intellectual property rights to lock out competition. The products are generally the same in concept (a four-wheel gas or electric vehicle with certain unique design features) and built/sold in remarkably the same way (internal design teams, multi-stage manufacturing processes, dealer-based sales). For instance, a company will likely achieve a limited dominance in certain demographic or regional areas through branding efforts or marketing messaging. Nowhere in this process is there a means to map out twenty years of market dominance.
Another industry - informatics - is entirely different. The ability to capture market dominance is easier because nearly every product feature is based on intellectual property. For instance, IMS Health (the company merged with Quintiles and renamed IQVIA in 2017) was known for collecting healthcare data, including de-identified pharmacy data, pharmaceutical sales data, medical claims, and other data. The company had a monopoly on prescribing data that they sold to pharmaceuticals, thereby capturing a market essential to guiding pharmaceuticals to market and promote to in their sales teams. No other could provide this data as IMS had exclusivity in its sources. Thousands of companies have access to proprietary data when you think of it, which they repackage and sell to customers. The informatics market is replete with wide moat, small companies which are outstanding investment opportunities.
Examples of Small Wide Moat Markets: Some examples of markets can be found in all parts of the economy. Some include financials, healthcare, technology, and others. Nearly all of these are niche markets with similar characteristics – proprietary technology/data and platforms deeply embedded in client operations. The first is financial data. Examples of this include former Nintai holding FactSet Research (FDS), another former Nintai holding Morningstar (MORN), and Bloomberg (privately held). These three companies have growing opportunities in the financial industry with a focus on stock information, trading data, etc. Their proprietary databases and platforms are essential tools, and their platforms are an intricate part of much of the industry's operations. Many companies simply couldn't run without their services.
Another industry is healthcare informatics. Here there are several sub-markets with powerful competitive moats. The first is pharmaceutical prescription data which I discussed previously using IQVIA as an example. A second is the electronic health record (EHR) market. Nearly every hospital utilizes an EHR to coordinate patient care, manage patient records, oversee drug prescribing, and control imaging such as x-rays or MRIs. EHRs are the platform on which nearly every hospital's operations run these days. Making a decision on which vendor to use is not only a multi-million dollar commitment but a decade-long decision that requires years of planning, training, implementation, and maintenance. Once a health system decides on which EHR vendor to work with, it takes something pretty drastic to force them to replace that vendor. Consequently, the EHR market is replete with highly profitable, wide-moat companies.
High Margin Business Models: There are many business models that generate hefty profits even with small margins. An example of this includes the big box retailers, including both general merchandisers like Walmart (WMT) and Target (TGT) and specialty retailers such as Home Depot (HD), Lowes (LOW), or Best Buy (BBY). These companies can create wide moats but generally don't meet the quality standards we look for at Nintai. Using Walmart as an example, let's compare it versus Nintai Investments' holding Masimo (MASI). Walmart's gross, net, and free cash flow margins were 24.8%, 2.4%, and 4.6% in 2020. During the same period, Masimo generated 65.0%, 21.0%, and 16.3%, respectively. Walmart generated a return on invested capital of 8.3%, while Masimo generated a 39.7% ROIC. Walmart's debt to equity ratio (meaning how much debt does the company have as a percentage of its total equity) is 0.78 (short-term debt and capital lease obligation of $5.3B plus long-term debt and capital lease obligations of $60.0B versus total equity of $81.3B). Masimo's debt to equity ratio is 0.02 (no debt and total capital lease obligations of $34M versus total equity of $1.41B)
While both companies have wide moats, Walmart's financial quality is considerably less than Masimo's (at least using Nintai's criteria). Masimo is more profitable, utilizes capital at a much higher rate, and has a fortress-like balance sheet. I should point out either company could be an outstanding or poor investment candidate given certain conditions. Walmart has been an excellent investment over the past 40 years. But given our druthers at Nintai, we'd prefer a company with high margins in a high margin business model than a low margin business in a moderate profit business model.
Product/Services Create Monopolistic Opportunities: One of the things most overlooked in finding quality investment opportunities is seeking out companies that operate in industries where their product or service inherently creates quality and profitability in both good and bad economies. To do this, a company must have a product that is part of their customers' core business by its very nature. This is different than the EHR model I discussed earlier. There the product was deeply embedded in the business process of their customer. Would it be hard to rip the product out and replace it? Absolutely. Could the hospital operate if the systems went down? Surely. With difficulty, but they could certainly still operate. In this category, we look for companies that as the customer utilizes the product, it becomes nearly impossible to function without it.
A great example of this is credit cards. Try to imagine going through an average day having only checks and cash (since most credit card issuer networks also issue debit cards, I count them as the same for this exercise). Think of the daily activities where it takes a credit card to complete the transaction. Everything from purchasing gas to shopping at Amazon, renting a car, or staying at a hotel, many consumers would have to change their daily schedule drastically – or eliminate some tasks – if they lost the ability to use a credit card.
Issues to Think About
Identifying industries or markets that have high percentages of quality-driven companies is only part of the research necessary. Whenever you find a niche that allows for highly profitable business models, you will likely find competition close on the leader’s heels. Capital flows to business strategies and markets that generate high returns. It makes sense. Success breeds success. Success breeds envy. Envy breeds greed. And greed breeds competition. So when you find that highly successful business model or market, remember to think about the following issues.
Capital Flows to Success: Name any type of business that successfully grew from a startup to an industry heavyweight, and you will find numberless competitors seeking to break into the same market. A great example of this was office supply big-box stores. After the success of Staples, an astounding 131 companies received venture capital or private equity funding over the next half-decade. A company that creates a market niche with high profits will inevitably face an onslaught of new competitors seeking to steal that company's customers or market share. To see this in action, take any six months and follow the investments of the private equity community. You will likely see many investments in one niche market where managers have focused on outsized profits. One quarter might be drug laboratories and the following real estate informatics. Inevitably, profits in those markets drop after such a massive influx of capital.
Speed of Innovation/Product Development: Some industries see innovation take place much faster than others. For instance, the automobile industry has been notoriously slow in adopting innovation. The combustion engine has reigned supreme for nearly one hundred years regardless of new technologies that would be far energy efficient. On the other hand, the semiconductor industry has been a continuous struggle to keep up with innovation. Here moats are dug and filled in no time. Finding an industry where innovation widens moats over time is a prescription for long-term outperformance.
Customer Fads: Some industries are prone to customer fads that come and go with remarkable speed. We've all heard of them – Ouija Boards, Game Boys, Beanie Babies, and Rubik's Cubes. These times may temporarily cause stock prices to suddenly soar but are just as likely to drop like a…..pet rock. Certain industries – like consumer electronics – come to mind when you think of industries that suffer from such market fads. If you choose to dip your toes in these waters, just be aware of the strength and depth of the moat. There's a big difference between a game whose name becomes part of our lexicon like Monopoly ("you're spending like it's monopoly money") versus Tickle Me Elmo.
The adage goes, "fish where the fish are." No doubt, sound advice if your survival depends on successfully catching fish. Investing is no different. When looking for value-priced quality companies, start looking in industries with a penchant for wide-moat businesses. These markets may be hard to locate initially. Some industries take a great deal of research to find the underlying reasons for their wide moat (pharmaceutical informatics) versus those staring us in the face (pipelines). But once you've found such a sweet spot, spend a good deal of time understanding the industry dynamics and the sources of its moats. Like the hunter-gatherers of old, you might be fishing there for quite a while.