Quality traps and how to avoid them to protect returns

The competitive advantage period part 2

I was honored to participate in a Dutch podcast episode of “Jong Beleggen” this past week.

If you’re Dutch-speaking, I recommend you check out their latest episode by following the link below.

If you don’t speak Dutch, then below you’ll find the English version of the topics we discussed. Thanks to Pim Verlaan and Milou Brand, I learned about Quality Traps. I had never heard of the term before preparing for this podcast.

If you listened to the podcast and stumbled upon this site, I recommend you to scroll down to the quality trap part where I explain what you can do to avoid them (or just go to the START HERE article).

This article is a deeper dive based on a previous article I wrote some time ago:

Are discounted cash flow models useless?

There’s also a Twitter thread available if you just want to go through the summary of it all. Just click the image below:

The setup for today:

  1. What is a competitive advantage?
  2. What is a MOAT?
  3. The competitive advantage period (CAP)
  4. The CAP by industry
  5. The link between CAP and DCF
  6. How do you calculate the CAP?
  7. The growth advantage period (GAP)
  8. CAP, GAP, and Quality Traps
  9. Summary and takeaways

What is a competitive advantage?

A company has a competitive advantage compared to its competition:

• If it offers a product/service that is made at a much lower cost (cost-leadership)

• If it offers a product/service that is so unique that a premium price can be charged for it (product leadership)

A combination of these two is of course Walhalla.

• Cost leaders are companies such as Costco, Ryanair, Ikea

• Product leaders are companies such as Apple, Tesla, Ferrari

Now you can look for the reasons why they enjoy this competitive advantage by looking at the operations of the company.

You can divide these benefits into 2 groups. An advantage on the consumer side or on the production side of the company. Check out our previous article on MOAT analysis if you want to dig a lot deeper.

Possible benefits (consumer)

• Habits: the taste of Coca-Cola, smartphone applications (Tik Tok)

• Customer experience: a service or product that delivers a unique experience

• High switching costs (lock-in): think of software Enterprise Resource Planning (ERP) systems: 

There is a saying: Changing ERP systems is like going to the dentist without anesthesia.

• Network effects: The product gets better as it has more users (see episode 68), with Facebook being the best-known example

Possible benefits (production)

• Great complexity of the process

• Patents or intellectual property with temporary protection

• The use of unique resources or materials

• Economies of scale

  • Large distribution capacity

  • Better purchasing power due to scale

• R&D possibility for new developments

A company with a competitive advantage has a higher ROIC than its competitors. However, not every company with a high ROIC has a competitive advantage. For example, a high ROIC may be the result of a cycle in which the company rides a wave of profitability across the industry. Some companies had a fairly good ROIC during ZIRP (Zero Interest Rate Policy), but that situation has changed.

A MOAT is more than a competitive advantage.

What is a MOAT?

Every company has a life cycle and jumps through different phases. A startup starts with a small home. As the startup scales up, it will expand its home and build a first line of defense around its home. If the competitive advantage becomes stronger and continues to grow, the buildings can grow into a castle, with a large moat around it (and crocodiles or piranhas in it). The company now has a MOAT.

A MOAT is a durable competitive advantage. The word durable or duration is important. It is sometimes said that you only know that a company has a real MOAT if it was able to fend off attackers and that its MOAT has been tested.

Microcaps rarely have a MOAT. Bigger quality compounders do.

Well-known quality companies with a MOAT are:

• Visa (P/E = 29)

• Costco (P/E = 52)

• Microsoft (P/E = 40)

The current P/E for the S&P500 is 28 and the historical median is 15. Is the P/E a good benchmark?

Yes and no, we will go into this in more detail.

The quality investment process that Buffett applies is simple:

1. Find a company with a MOAT

2. What ensures that the MOAT is durable?

3. Will the lord of the castle keep profits for himself or share with others? (how will he divide the capital?)

Although step number 3 is crucial, we won’t be delving deeper into capital allocation today. You can check out a previous article with a checklist here.

Nothing is said here about the price he pays. Know that Buffett seldom paid more than a P/E of 15 for his companies. 

Does a MOAT make a big difference? 

Morningstar uses the following classification to rank companies based on the strength of MOAT:

• no MOATS

• narrow MOAT

• wide MOATs

They looked at the return of this group of companies over 5 and 10 years. Here is the result:

Quality can lead to an additional return of 2-3% per year.

From MOAT to valuation: Competitive advantage period

First, let's go back to the building blocks of a company's intrinsic value. The intrinsic value is the sum of all future cash flows. That sounds simple, but in practice is quite difficult to determine.

“Warren often talks about these discounted cash flows, but I've never seen him do one. If it isn't perfectly obvious that it's going to work out well if you do the calculation, then he tends to go on to the next idea.”

-Charlie Munger

You have to forecast the future growth profile of the company, based on all the information you can find. To do that, you need to know if the company has a MOAT and if so how strong it is.

The economic value that a company creates is the product of:

• The spread: ROIC-WACC

• Its invested capital

• The Competitive Advantage period (CAP): The duration which allows the company to generate a ROIC that is higher than its WACC on new investments

This CAP was introduced in 1961 by Miller and Modigliani but is little used or mentioned nowadays. 

Below you can find the formulas for illustration purposes. 

The most important thing to take into account is that the value of a company is split into 2 terms; a steady-state term and an excess return term. This may immediately remind you of a typical DCF where you will find the sum of the future cash flows (excess return) en terminal value (steady state).

From Mauboussin: CAP, the neglected value driver

Every company has a competitive cycle as presented below.

1. Innovation: A company starts up. Its ROIC < WACC. At some point, the company starts making a profit. A tipping point occurs. ROIC > WACC. There is value creation

2. Fade: Bezos: “Your margin is my opportunity.” Due to ever-increasing competition, the company's ROIC is decreasing. As long as the ROIC > WACC, the company continues to create value thanks to its competitive advantage. The competitive advantage period is the duration during which the company maintains its advantage and continues to create value

3. Mature: At some point, through competition, the ROIC equals the WACC. No more value is created

4. Decline: Better companies enter the market, and your ROIC now drops below the WACC. Value is destroyed.

This illustrates the principle of reversion to the mean. Powerful market effects ensure that a company loses its competitive edge.

Its edge fades away.

The Competitive Advantage Period or CAP is the duration of the MOAT of a company so that economic profits are protected from competition expressed in years.

CAP for different sectors

We can also represent the CAP as follows:

Source 

The Excess Return is represented by the area of ​​the triangle. You see that competition reduces ROIC. The CAP can now be determined for an entire industry. 

The CAP depends on:

• Level of ROIC

• Barriers to entry

• The speed at which the industry is changing

Suppose you have an industry where the barriers to entry are high, the speed of change is slow and the companies have a high ROIC, then you have a long CAP. 

Conversely, an industry without barriers to entry and lots of innovation and change where ROIC is lower will have a shorter CAP.

For a company in the United States, this CAP ranges from 10 to 15 years. The CAP can be calculated per company or per industry. Here's an overview of some industries in the US:

Let's take Coca-Cola as an example. 

The beverage industry is rather stable. It does have barriers to entry because everything revolves around distribution capabilities, economies of scale, and brand awareness (which Coca-Cola and Pepsi have). This translates into a long CAP (20 years)

This model also explains why Coca-Cola consistently trades around a P/E of 25. Its ROIC is currently 14%, which is good but not extremely high. However, the MOAT, predictability, and slow innovation in the industry mean that Coca-Cola has a long CAP. 

The long CAP contributes to a higher P/E in the market.

The length of the CAP has undergone an evolution In recent years. Companies need less and less capital (from hard to soft industry). Technological innovation is going faster and faster and sometimes generates excessive returns.

What effect does this have on the CAP?

Mauboussin: Innovation and the markets

This graph dates from the year 2000 but is still relevant.

We live in a time of a market dominated by companies with excessive returns but shorter caps. A world where more and more intangibles on the balance sheet have appeared, as opposed to the high capex hard industries in the past.

Think Coca-Cola versus Nvidia. Great profits and longer caps versus extreme profits and shorter caps. Although we’ll see how Nvidia will do in the next decade. These extreme profits may well deserve a premium in the market. Coca-Cola has been around for more than 100 years. Nvidia is now 31 years old.

Do you think Nvidia will reach 100?

The link between CAP and a DCF

The value of a company can be divided into 2 parts:

1. The growth of future cash flows (ROIC > WACC)

2. The terminal value (when ROIC = WACC)

However, why is the growth of cash flows always calculated for 5 to 10 years? 

Look at your hands.

This can explain why a DCF sometimes undervalues ​​a quality company. The duration of the competitive advantage period is usually simulated at 10 years. However, Microsoft's current CAP is estimated at 20 years. 

Does this mean that from now on we will be drawing up DCF models of 12 years or 18 years? 

That doesn't seem useful to me. 

However, the following is important:

• A typical DCF can lead to a too-conservative valuation

• Don't get hung up on a number, you want the direction to be correct and the margin of safety to be large

• The big advantage of a DCF is that it makes certain assumptions explicit

The importance of CAP is to use it as a mental model: How long do you think a company can defend its MOAT?

The better you understand the MOAT, the better you can draw up a DCF and, above all, interpret the result.

Market-Implied CAP

When you use a reverse DCF, you use the price and enterprise value in the market to calculate cash flow growth. You can then judge whether you think the company will do better or worse.

The values ​​entered in your model are:

• Duration = 10 years = CAP

• Basic FCF in Year 1

• Discount rate

• Growth rate for your terminal value (lower than GDP growth)

You can also calculate the Market Implied CAP (MICAP) this way, but here you have to keep the growth rate constant. Calculate this for different durations until you arrive at the current value of the company. 

You can then compare the duration you have with the industry and possibly other competitors, to make a judgment about the possible under or overvaluation of the company.

Here you can find an example. Take this method of valuation with you as an additional tool in your valuation toolbox.

A Quality Trap?

Most investors are familiar with a value trap. You see a company that is apparently cheap. However, after your investment, the company does not improve or the market does not recognize the underlying value. In other words, you have been lured into a trap by an apparent bargain.

In the 22nd annual study of value creation, Motilal Oswal, a finance company, introduced the concept of the Quality Trap.

They introduced a second variable in addition to the CAP. The GAP or growth advantage period. This is the period during which a company’s profits grow faster than the benchmark indices. Just like the CAP, the GAP can be represented as follows:

Source: From Motilal Oswal

The GAP is influenced by the size of the CAP and the growth of the industry as a whole.

When you now combine the CAP (MOAT) and GAP (GROWTH) you get the following matrix:

From Motilal Oswal, adapted by the author

4 possibilities are available

1. The company has a weak MOAT and low growth, these are the companies that destroy value: WEALTH DESTROYERS

2. The company has a weak MOAT but high growth. These companies temporarily achieve a good return: GROWTH TRAPS

3. The company has a strong MOAT but low growth, these are the QUALITY TRAPS. They can lead to lower returns than originally expected

4. Finally, the company has both, then you come to the multi-baggers of the TRUE WEALTH CREATORS justifiably

When we think of the current markets and the past couple of years, you can see that:

• WEALTH CREATORS: Big tech who has carried the market

• WEALTH DESTROYERS: Airline companies

• GROWTH TRAPS: Cyclical companies or certain companies that were boosted by COVID. They didn’t have a real MOAT

• QUALITY TRAPS: Companies that appear to have a durable MOAT and long CAP, but profit growth is slower than the overall market.

The notion of quality traps is particularly important here. It is the combination of CAP and sufficient growth that will determine the outcome of your investment in quality companies. 

Would you like to go into more detail about this? then consult the full study in PDF.

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Intermezzo: Terry Smith, is quality expensive?

Quality deserves a premium. 

If you buy a Mercedes, you pay more, but you also expect the “German gründlichkeit” in return. The price/quality ratio may be higher than if you had bought a Lada that then continuously breaks down after 6 months.

The most used way to see how expensive or cheap a share is is still the price-earnings ratio. But therein lies the problem. 

• A high P/E does not necessarily tell you anything about the quality of the company.

• A low P/E does not mean you are making a bargain.

First and foremost, let's look at an interesting study from Terry Smith in his January 2022 shareholder letter.

Terry has calculated at which multiples you could have bought the companies below to achieve a return of 7% over approximately 45 years.

From Smithfund 2022 shareholder letter

If you had bought L'Oréal in 1973 at a P/E of a whopping 281, you would have still outperformed the MSCI World Index.

A period of 45 years is very long, but it is an interesting theoretical exercise that shows that quality, as we have seen with the DCF, is regularly undervalued.

That aside, Terry would never buy such multiples. It shows the value of quality appears over the long term.

The most important factor when investing in quality stocks is patience. Patience to wait until the price is low enough. Patience to be able to hold the share for the long term.

Investing is where you find a few great companies and then sit on your ass.

-Charlie Munger

We end with some comments regarding the P/E ratio. 

Most websites or screeners show you the TTM (sum of the last 4 quarters) P/E. However, what you want to know is what will happen in the future.

• What about the forward P/E?

• Are we looking at normalized profits?

• How close are profits to operating cash flow?

The P/E ratio compared to the past only makes sense if the context and business strength are similar. Is the P/E at its lowest value ever? 

The market might be right if the quality of the company has declined during that period.

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So what to do to avoid quality traps?

Don’t overpay. 

We’re getting used to paying P/E’s of 20 to 30 for Quality Companies. If we pay these kinds of prices, we have to be convinced the Competitive Advantage Period is long as there is no room for a multiple expansion. There is no room for error. All performance has to come from EPS growth.

Compare the growth rate to the market. 

If you think the company has a strong MOAT and a long CAP, has the past earnings growth been higher than the market? This way, if growth slows down, you have a small buffer to start from. If earnings growth has been lower, even with a long CAP, you might not get the returns you want.

Short-term pain for the Long-term gain

Look for signs of management making decisions that leave money on the table in the short term but will add value in the long term. Jeff Bezos was very explicit about this in his shareholder letters. If you can find management that thinks long-term and understands the need to continue to build and protect their MOAT, then you have a team that is actively thinking about lengthening their CAP. If they can execute, it will protect your returns. And if they manage to lengthen the CAP, then the risk of multiple compression decreases.

Summary

1. Every company has a competitive life cycle

2. Every company has a CAP or Competitive Advantage Period, the duration where its ROIC is greater than its WACC for new investments. The durability of its MOAT is expressed in years.

3. Every company will try to Increase ROIC or extend CAP to be extended

4. The CAP depends on the MOAT of the company and the industry in which it is located.

5. You can determine the CAP (expressed in years) of a company based on the current price in the market (as you use a reverse DCF). You then take a certain expected growth and then calculate the duration (instead of calculating the growth term)

6. From MOAT to CAP to valuation. The CAP is another way of looking at valuation (mental model). It's an extra tool in your toolbox.

7. The CAP explains why seemingly stable companies that are quite profitable are highly priced in the market

8. By analogy with the value trap, there is a quality trap. Be careful with your entry price. Does the company still have sufficient growth? Are they investing in the long term?

I’m planning to dive deeper into these quality traps and see if Dino Polska is not one of them. 

As always, may the markets be with you!

Kevin

P.S.

As CAP is a concept, and may be difficult to put into practice (except when calculating the implied CAP) I’ve added a section on how you could approach valuation of a quality company.

Bonus section: How to value quality?

In addition to the CAP and implied CAP, there are two more classic methods of valuation. 

We now know that understanding a company's MOAT can help us imagine how it will perform in the future. That quality is usually quoted at a premium in the market and the P/E says nothing about the quality of a company.

How can we best value such companies?

The method you use to determine value should take into account what stage of the cycle the company is in.

Kris

from multi-bagger nuggets has made a nice infographic of this:

If we want to buy quality companies that have already won, then you're in phases 4 and 5. We can then use the P/E ratio or Discounted Cash Flow.

We choose to use the following 2 methods:

• A reverse DCF: Why? Instead of determining a precise value, we will look for what the growth expectations are of the current price in the market. We then have to assess whether we think the company will grow faster(undervalued) or slower(overvalued).

• Earnings growth model: Why? It takes into account not only growth but also how the lord of the castle distributes his capital. The earnings growth model is based on where exactly your investment return comes from. You’ll also have to forecast a possible multiple compression or expansion.

Reverse DCF

Suppose your discount rate is 10% and the term of your DCF is 10 years. You then look for which combination of start, free cash flows, and future growth can explain the current price in the market. 

Once you have that combination, the question becomes:

Based on historical figures and your analysis of the MOAT, do you think the company will perform better or worse over the next 10 years?

• Better? Then the company is undervalued

• Fewer? Then the company is overvalued

You can also pit different combinations against each other, which will give you a table that looks like this:

You can download the Excel file here.

Earnings growth model

The earnings growth model is based on which elements exactly deliver a return for the shareholder:

Source: Morgan Stanley

It's an interesting way to imagine the return of a quality company, as they usually have continuous profit growth and can pay dividends or buy back shares. You can then compare the result with your hurdle rate or the return you want.

The calculation looks like this:

Expected annual return=

• Growth in earnings per share

• +/- P/W expansion or contraction

• + buyback yield

• + dividend yield

You can calculate this over any period, but 10 years is usually chosen.

Here you need to make an estimate of:

1. What will be the future growth of the normalized profits

2. Or one buyback yield of dividend yield can be assumed

3. Or one in the next 10 years a multiple expansion or contraction will take place

It is especially in this 3rd step that you have to take into account with your analysis of how strong the company's MOAT is, and how the ROIC will evolve in the future.

You can recalculate this for different combinations of earnings growth and multiple contraction or expansion. You will then get the following heat map:

You can download the Excel file here.