Warren Buffett has said many a wise thing about investing but none wiser than this:
“If you gave me $100 billion and said, ‘Take away the soft drink leadership of Coca-Cola in the world,’ I’d give it back to you and tell you that it can’t be done.”
What did he mean by this statement? Simply this: Good businesses have intangible strengths and qualities that simply cannot be purchased at any price. They are difficult, if not impossible, to quantify, reproduce, or copy by competitors in the marketplace.
Moreover, these intangible qualities tend to be leading indicators of a company’s success. You can easily look at intangibles such as brand, market position, customer loyalty, innovation strength, channel strength, and management to determine, at least to a degree, how well the company will do financially down the road. At the risk of oversimplifying, financials are the past, while intangibles are the future.
As you appraise any company as a possible investment, you should get into the habit of examining both the financials and the intangibles that make the company tick.
When you look at any company, perhaps the bottom-line question follows the Buffett wisdom: If you yourself had a hundred billion in cool cash to spend—and the genius intellect to spend it right—could you recreate that company?
If the answer is “yes,” it may still be a great company, but it may not be great enough to fend off competition and keep its customers forever. If the answer is “no,” the company truly has something unique to offer in the marketplace, difficult to duplicate at any cost. That sustainable competitive edge—whether it’s a brand, a trade secret, or a lock on distribution or supply channels, may be worth more than all the factories, high-rise office buildings. and cash in the bank a company could ever have.
Intangibles are the “soft” factors that make companies unique. They add up to more than the sum of their parts; they’re the factors that define excellence and future financial results. Strategic intangibles are among the many that are so important; they shouldn’t be overlooked. Here are questions you should ask about seven key intangibles. (These seven are the most important for most businesses and industries, although some industries may have some unique ones, such as intellectual property in the technology sector.)
Does the Company Have a Moat?
As you’re looking at the intangibles, you should ask yourself whether the company has a “moat?” and if so, is it a “wide” or a “narrow” one. What do I mean by a “moat?”
A business “moat” performs much the same role as its medieval equivalent—it protects the business from competition. Whatever factors—which are mostly intangibles—that create the moat, ultimately those are the ones that prevent you, armed though you may be with Mr. Buffett’s $100 billion to invest, from taking their business. Moats are usually a combination of brand, product technology, design, marketing and distribution channels, and customer loyalty all working together to protect a company. A moat doesn’t just protect the existence of a company, it helps it command higher prices and earn higher profits.
Whether a company has a “narrow” moat, a “wide” moat, or none at all is a subjective assessment you must make. However, you can get some help at Morningstar (www.morningstar.com), whose stock ratings include an assessment of the moat.
Coca-Cola has a moat because of the sheer impossibility of surpassing its brand and brand recognition worldwide. Intel has a moat because of its lead in microprocessor design and has unbeatable brand recognition. CarMax has a moat because it is further along in putting retail-style dealerships on the ground and applying management information technologies to its business than anyone else is; it would take years for a competitor to catch up. Tiffany has a moat because of its immediately recognized brand and elegantly simple, stylish brand image and the enduring and timeless panache around that.
The moat, usually defined by its intangibles taken as a whole, represents a company’s competitive advantage. A company without a moat is basically producing a commodity and typically has little to compete on besides price.
Does the Company Have an Excellent Brand?
It’s hard to say enough about brand, especially in today’s fast-moving, highly packaged, highly national and international marketplace. A strong brand means consistency and a promise to consumers, and consumers sold on a brand will prefer it over any other, almost regardless of price. People still buy Tide; Starbucks is still synonymous with high quality and ambience. Good brands command higher prices and foster loyalty and identity—even customer “love.”
Ask yourself if a company has a sought-after brand, a brand customers would pay extra to buy or align with, a brand that would be difficult to duplicate at any cost. Would customers rather fight than switch? Think about Starbucks, Coca-Cola, Heinz, Tiffany, Nike, or the brands within a house, like Frito-Lay (Pepsi), Tide (P&G), or Teflon (DuPont). Don’t forget about brands in the business-to-business marketplace either—Caterpillar, 3M, Lubrizol, Safety-Kleen, Fastenal, SENCO and others.
Is the Company a Market Leader?
Market leadership usually, but not always, goes hand in hand with brand. The trick is to decide whether a company really leads in its industry. Often, but not always, that’s a factor of size. The market leader usually has the highest market share, and the important point is that it calls the shots with regard to price, technology, marketing message, and so forth—other companies must play catch-up and often discount their prices to keep up. Apple is a market leader in personal electronics and digital music, Intel is the market leader in microprocessors, and Whirlpool is the market leader in home appliances.
Excellent companies tend to be market leaders, and market leaders tend to be excellent companies. But this relationship doesn’t always hold true—sometimes the nimble but smaller competitor is the excellent company and will likely assume market leadership eventually. Examples such as CarMax, Nucor, Perrigo, Valero, and Southwest Airlines are easy to spot.
Successful investors also think about market positioning. Is the company a price leader? A quality leader? A customer service leader? Does it represent the low end (Walmart), the high end (Nordstrom), or the middle (Target)? Is it clear what part of the market it targets? Does it do it well? Is it the leader in that space? The marketplace is littered with unsuccessful companies that either couldn’t figure out what they stood for, or couldn’t achieve it once decided. More on this in Habit 13: Put on Your Marketing Hat.
Does the Company Have Loyal Customers?
You won’t know for sure, but a quick examination of the marketplace—and your own experiences—might give a clue about whether customers would rather fight than switch. Estimates from the mobile phone industry and others indicate that it costs about seven times as much to acquire a new customer as to retain an existing one, so a company that has loyalty is doing something right. Loyalty can be created by, or goes hand in hand with, brand, as in the case of Starbucks. It can be created by solid customer service (Sears, John Deere, Caterpillar) or by product excellence, innovation, and design (Apple and Tiffany).
Also note whether companies do things to damage their reputations, and observe what (if anything) they do about it. Many become public spectacles, such as BP during the Gulf oil-spill disaster; these are eventually handled well and at some point cease to cost the company. Damage can also be very small and localized—even in things as simple as customer service (Starbucks’ reputation for long lines, for instance). It’s good to observe what companies do about such inhibitors and how fast and well they do it.
Most of us associate innovations with technology and technology companies, which are in the business of inventing and selling things that make business and personal life easier, better, or faster. But innovation goes far beyond the products that a company sells. And it isn’t just about ideas—many companies “invent”—that is, develop new things and may even patent them. But far fewer “innovate”—that is, create new things that economically solve a customer problem and will, as a result, succeed in the marketplace.
Smart investors sniff out innovation and decide whether a company’s innovations and innovation habits are a competitive advantage.
Innovation isn’t just about products and widgets sold at your local big box electronics outlet. It can also be, and it may be, a real source of competitive advantage about whether a company makes the best use of technology to make operations and customer interfaces as efficient and effective as possible. Companies that don’t seem so innovative on the surface may turn out to be on closer examination. UPS, for example, is current developing a system with which customers can schedule their own deliveries online within a delivery window. This will greatly increase UPS’s preference for valuable e-commerce shipments to busy people.
Be careful here, however. Just because a company has an innovation, it doesn’t mean that it will lead to market—and ultimately financial—success. UPS may have a good idea and may have emphasized it in their company PR and advertising. But can the company actually execute on the innovation; that is, does it work? How easy, and how quickly, can the competition copy it? Will FedEx roll out the same service feature two months later? Innovations must be leading, useful, effective, and sustainable to really count—otherwise all that the company is really doing is keeping up.
Some innovations are particularly subtle but effective. Southwest Airlines excels today not only because of brand and management excellence, but also because of innovation excellence. Why? Simply because, after all of these years, they still have the best, simplest, and easiest-to-use flight booking and check-in in the industry. The innovation seems to be just as much about design and customer experience as it is about technology, but it works. Sometimes these sorts of innovations mean a lot more than bringing new, fancy products with bells and whistles to the market.
Does the Company Have Channel Excellence?
“Channels” in business parlance means a chain of players to sell and distribute a company’s products. It might be stores; it might be other industrial companies; it might be direct to the consumer. If a company is considered a top supplier in a particular channel or a company has especially good relations with its channel, that’s a plus.
Excellent companies develop solid channel relationships and become the preferred supplier in those channels. Companies such as Nike, Pepsi, Procter & Gamble, and Whirlpool all have excellent relationships with the channels through which they sell their product.
Does the Company Have Supply Chain Excellence?
Like distribution channels, excellent companies develop excellent low-cost supply channels. They are seldom caught off guard by supply shortages and tend to get favorable and stable prices for whatever they buy. This is often not an easy assessment unless you know something about a particular industry. Nike and Target are good examples of companies that have done a good job of managing their supply chains.
Does the Company Have Excellent Management?
Well, it’s not hard to grasp what happens if a company doesn’t have good management; performance fails and few inside or outside the company respect the company. It’s not easy for an investor to determine if a management team does a good job or acts in shareholder interests. Clues can include candor and honesty and the ability of company management to speak in accessible, easily understood terms about the company and company performance. (It’s worth listening to conference calls as a resource.) A management team that admits errors and eschews other forms of arrogance and entitlement (e.g., luxury perks, office suites, aircraft) is probably tilting its interests toward shareholders. So too is the management team that can cough up some return to shareholders once in a while in the form of a dividend.
This may be the most subjective and elusive assessment of all, as few investors work with these folks on a daily basis. Still, over time, you can garner a strong hunch about whether a management team is effective and on your side. For more see Habit 15: Sense the Management Style.
While most sources of investing information present at least some of the key financial information you’d look for, it can be harder to gather information on intangibles. Most financial reports contain only bits and pieces of material listed above. Certainly none do it in a manner that follows this outline.
So what to do? You’ll have to be creative. You’ll have to track the financial media, look at company websites and reports, listen to what people have to say about their experiences with the company, and become familiar with the industry. Getting a picture of the intangibles is more about absorption, interpretation, and experience than it is about reading lists of facts. You’ll want to read what the company says about itself, see how it presents itself and behaves in the marketplace, and hear what others have to say about it.
The outline just presented will help—just ask yourself whether a company has an excellent brand, a solid market position, good innovation, solid management, and so forth. You may answer some definitively, while others will be an “I don’t know.” That’s okay, and over time you’ll pick up signals that strengthen your assessment. If most of your answers are “I don’t know,” however, you might want to stay away from the investment, at least for now.
WHY CAN’T I GET THIS STRAIGHT FROM THE COMPANY?
Wouldn’t it be nice if the SEC required companies to report these intangibles in their financial statements and annual reports, using some sort of common format like this? Well, chances are, companies would fight such a rule, because it would get to the core of what many might consider proprietary information or secrets.
If companies had to report on intangibles … well, it might be a pretty intangible report, as much of it goes beyond simple facts to an interpretation or explanation of a lot of experience and events. It is a story. And as we all know, stories can be altered and embellished to say what we want to say and what we want people to hear.
• Recognize and realize that intangibles are about the future, while financials are about the past.
• Look for “moats”—sustainable competitive advantages.
• Examine, one by one, the following (some may be more elusive than others):
• Brand
• Market leadership and position
• Customer loyalty
• Innovation excellence
• Channel excellence
• Supply chain excellence
• Management excellence
• Absorb intangible information by regularly reading about the company in the news, visits to the company and/or its websites, and listening to what others—personal or professional—have to say about the company.