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Peter Thiel on Moats, Valuation & How to Think

Discussion in 'Medium/Long Term Investing' started by RickyY, Mar 31, 2019.

  1. RickyY

    RickyY

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    Peter Thiel is a co-founder of PayPal and Palantir Technologies, which specialized in big data analytics. While it is more apt to call him a tech entrepreneur than an investor, he knows something about moats and good thinking.

    Peter Thiel explains the differences between perfect competition and monopoly:

    “Every firm in a competitive market is undifferentiated and sells the same homogeneous products. Since no firm has any market power, they must all sell at whatever price the market determines. If there is money to be made, new firms will enter the market, increase supply, drive prices down, and thereby eliminate the profits that attracted them in the first place. If too many firms enter the market, they’ll suffer losses, some will fold, and prices will rise back to sustainable levels. Under perfect competition, in the long run no company makes an economic profit.”

    “The opposite of perfect competition is monopoly. Whereas a competitive firm must sell at the market price, a monopoly owns its market, so it can set its own prices. Since it has no competition, it produces at the quantity and price combination that maximizes its profits.”

    Companies operating under the perfect competition environment can only earn a return similar to its cost over the long run because there is no barrier to prevent new entrants from entering the market. As a result, all economic profit gets competed away in the long run. In contrast, monopolies are companies that possess moats. Moats create a barrier that allows them to retain the majority of the profit and earn a return above its cost (economic profit) over the long run. These moats can come in the form of scale economies, network effect, switching cost, branding, counter-positioning, cornered resources, and process power. The nature of these two environments also points to something subtle: high growth industries doesn’t guarantee winners.

    “Your company could create a lot of value without becoming very valuable itself. Creating value is not enough—you also need to capture some of the value you create.”

    There is a misconception that the best place to find great companies or future monopolies is in high growth industries i.e artificial intelligence, self-driving, robotic, lithium, cannabis etc. But think of some high growth industries in the past that produce enormous value to the economy from automobile, television to personal computer and internet, how many companies in these industries end up as monopolies? And how many that didn’t? If anything, high growth industries are the hotbed of perfect competition.

    The precondition of a company to have moat is its ability to defend its profits. In other words, the ability to capture value is what differentiates monopoly from perfect competition, not the growth rate of the industry. Perfect competition is like everyone in the crowd decides to tiptoe to get a better view of a parade. The end result is no one gets it. This also illustrates the danger of financial modeling that often ignores the second-order effect. Your financial modeling might show positive NPV (net present value) for a piece of state-of-art machinery that can increase production by 50%, but the question is, do you have the ability to retain those profits or will they get passed onto the customers in the form lower selling price once your competitors get their hand on that machine?

    “Growth is easy to measure, but durability isn’t. Those who succumb to measurement mania obsess about weekly active user statistics, monthly revenue targets, and quarterly earnings reports. However, you can hit those numbers and still overlook deeper, harder-to-measure problems that threaten the durability of your business.”

    “If you focus on near-term growth above all else, you miss the most important question you should be asking: will this business still be around a decade from now? Numbers alone won’t tell you the answer; instead you must think critically about the qualitative characteristics of your business.”


    This is the hard part of investing, and also the fun part of it. Quantitative metrics tell you the past growth rate but it rarely reveals the durability of a business. And growth is only as good as the ability to defend it. A fast-growing business that has zero durability is not worth any more than a business that has no growth. The right question to ask is not whether earnings are growing, but “is the company building or growing its moat?” The durability of the moat is the uncountable that counts. A strong earnings track record is not evidence of a moat just as a lack of growth is not the absence of one. For one, companies that are growing their moat generally have high capital expenditure and expenses going into distribution, sales or R&D, and generate negative cash flow in the process.

    “Simply stated, the value of a business today is the sum of all the money it will make in the future.”

    What you’re trying to estimate is the future cash flow, not what’s in the past. What has been invested in the business over the past 10 years and the cash flow it generates thereafter is not important. What’s important is the capital allocation decision made today. What is the expected future cash flow for these investments? In order to answer that, you need to have a good grasp on the durability of a business. And to understand durability, first, you have to understand the 7 moats.



    Notes

    Thiel, P. & Masters, B. (2014). Zero to One Notes on Startups, or How to Build the Future: Virgin Books
     
    peter2 and Knobby22 like this.
  2. Knobby22

    Knobby22 Mmmmmm 2nd breakfast

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    That is how I look at things.
    One of the factors in investing.
     
  3. ducati916

    ducati916

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    Essentially nonsense.

    Pure [perfect] competition is defined as that state in which the demand curve for each firm in an economy is perfectly elastic.

    In this state of affairs, no single firm can, through any [of its] actions, have any effect or influence over the price of its product. Its price is set by the market. This is fallacious.

    At some point, an increase in supply will cause a fall in price. Thus the theory of perfect competition fails and is demonstrated to be false.

    jog on
    duc
     
  4. Value Hunter

    Value Hunter

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    The other problem with the theory of perfect competition is that its based on the assumption that we companies operate in a purely "capitalist" economy.

    In fact large companies (especially in U.S.A.) operate in a crony capitalist rent seeking society which means that competition is far removed from the ideals of perfect competition. Various metrics indicate that competition has lessened over time in most industries due to concentration of power and due to crony capitalism. This becomes crystal clear when looking at various metrics like the profit margins of the S&P 500 (around record highs of 11.5% compared to long term average of around 6%), return on equity of the S&P 500, trends for market share of the biggest companies in each industry, wage stagnation, etc.

    While moats are important you can still have companies that are excellent investments and generate strong long-term growth despite the absence of a moat and you can likewise have companies with wide (but shrinking) moats which turn out to be poor performers.

    An example would be certain insurance companies internationally (for example some owned by Berkshire Hathaway) that have little or no moat but do well due to having strong balance sheets, good management and most importantly strong underwriting discipline. Another example is Credit Corp which has left other Australian debt collection companies in the dust despite having no moat due to having far superior management and a stronger balance sheet. Credit Corp has been performing strongly since it listed in the year 2000.

    Moats are important but they are not the be all and end all. Its important that investors react to emerging trends in consumer behavior, technology, regulation etc and take a 5 - 10 year view of these things and also reacting to the earnings momentum of a company. For example Walmart has a strong but shrinking moat (Low cost operator and wide distribution network). As more and more sales go to internet giants like Amazon long-term the outlook for Walmart is arguably not that bright. Earnings per share has gone backwards for at least 4 years now at yet the stock is almost at record highs. Its easy for investors who have long held the stock and made good gains to see this and get out of the stock.

    Another good example is Coca-Cola in the U.S.A. The brand power and the distribution network give Coke a very wide moat but the structural headwinds of price conscious consumers switching to private label colas (supermarket private label is a growing trend), tougher regulation in some countries like stricter labeling and sugar taxes, coupled with people moving away from unhealthy sugary drinks to products like Coconut water, kombucha, vitamin water, glacier water, cold pressed juice, etc means that (at least in developed markets) soft drinks are in structural decline. While its true that Coca-Cola owns a broad suite of products of all sorts of sport drinks, juice and water, etc products (some of them in growth categories) but none of those products have the history or brand strength of the Coca-Cola soft drink and are therefore are just another ordinary product in a crowded market place. Cokes earnings have been stagnant for years and yet the stock is near record highs. Long term Coke shareholders have a good chance to get out.

    The point I am trying to make is while the stock market reacts quickly and violently to short term news such as fed interest rate decisions and quarterly earnings surprises the stock market is often slow to react to long-term trends and this gives long-term focused investors plenty of time to get in or out of a stock without having to be a genius at predicting the future.
     
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