Some companies remain very profitable for a long time by creating economic moats to sustain these profits.
In an open market economy, companies can be rewarded with high profits by providing desirable products or services in new, untested or hard-to-address markets. These high profits are often short-lived. As soon as high profits are shown to be available, they attract competition, which will subsequently erode these high profits.
Some companies remain very profitable for a long time, however, by creating “economic moats” to make their competitive position durable. Economic moats are structural business attributes that help companies to generate high returns on capital for an extended period. These moats can be built from tangible capital, such as Amazon’s warehouses, which have expanded at a pace and scale that competitors cannot match. In the modern economy, moats are increasingly built from intangible capital: a lead in a particular technology, or a unique consumer offering, such as the moat around Netflix with its huge, hard-to-replicate content library.
We identify four major sources of economic moats:
Intangible assets: These include things that block competition and/or allow companies to charge more for their products and services, such as brands and patents. Think of ASML and Applied Materials, which make highly complex machines for producing semi-conductors and whose market position is protected by numerous patents; or Nestlé’s Nescafé brand, which is a leading player in the coffee market.
Network effects: The value of a particular good or service increases for both new and existing users as more customers use it. An example would be payment networks such as Visa or Mastercard, where increased penetration and acceptance adds to the value of the network.
Cost advantage: Sustainably lower costs than competitors can be achieved through irreplicable process advantages, superior location or access to a unique asset. Due to its vast scale, AWS, Amazon’s Web Services division, can provide web-based storage and computing capacity at a much lower cost per unit than traditional producers of locally used PCs and servers.
Switching costs: These can become an economic moat when they exceed the expected value of switching, or where switching would be too disruptive to the customer’s day-to-day operations. A great example is Microsoft: moving away from products such as Windows, Office and Azure would be extremely disruptive to many customers.
But where should we start in our search for companies with a durable competitive position?
In our view, the two most important indicators of quality companies with durable competitive positions are Cash Flow Return on Investment (our preferred indicator of economic profitability) and Asset Growth (our preferred indicator of life-cycle phase and competitive position).
Cash Flow Return on Investment (CFROI) is a ratio that measures, with minimal accounting distortions, a company’s economic performance. It tells us how efficient a company is in generating cash flow from the capital invested in its business, which is directly linked to the strength of its competitive position. Although it primarily denotes economic returns, CFROI is also a good indicator of the level of cash a company generates, which it can then reinvest to strengthen its current competitive position or adapt to societal change.
Asset Growth tells us a lot about whether a company is finding opportunities to invest, which generally come from operating in a growing addressable market, taking market share from competitors, or expanding into new markets. Ideally, companies grow their asset base in such a way that it strengthens their competitive position and increases their economic moat.
Although screening for companies with an attractive CFROI and Asset Growth profile is straightforward, it is key to determine whether this profile is persistent. For this, the team performs a fundamental bottom-up assessment of companies, which includes the use of the corporate lifecycle perspective, illustrated in figure 1.
Figure 1. Identifying Quality Compounders: The Corporate Lifecycle
Source: Neuberger Berman. For illustrative and discussion purposes only.
During this bottom-up assessment, we look for companies with a high CFROI and structural Asset Growth—what we call the “focus area” of the corporate lifecycle. We then determine whether these companies have a durable competitive position and how that is related to their positions in their specific value chains and the development of their end-markets. We also evaluate the opportunities a company has for deploying most of their cash flow into profitable new investments and new market opportunities.
The limited set of companies that makes it past this bottom-up assessment can be referred to as “quality compounders”: in addition to high CFROI and structural Asset Growth, they tend to exhibit other related signs of “quality,” such as higher-than-average sales growth and margins, lower financial leverage, and less cyclicality and earnings volatility. As we aim to solely invest in quality compounders, these characteristics can also be found in our portfolio.
These characteristics of quality compounders are unlikely to be found at the beginning of a corporate’s lifecycle, due to the high-risk nature of start-ups: based on our experience and insights, only a relatively small number of start-ups succeed. At the end of the corporate lifecycle, compounding typically moves into reverse as the products of a company become less relevant to the market—think of Spotify displacing CDs and CD players. This puts pressure on both CFROI and Asset Growth, as legacy assets become less profitable and eventually have to be liquidated. It is very hard to re-invent a company and move it back to the focus area, and it is therefore of paramount importance that the companies we invest in can adapt to change. They can achieve this by reinvesting their cashflows in such a way that they stay highly relevant and attractive to customers, and ultimately remain in the sweet spot of the corporate lifecycle.
