Business values are tied to 2 things, a competitive dynamic and perceived value by the purchaser.
Put these 2 pieces together and you end up with price. Please note this is a little more subtle than supply and demand and the framework varies with each market.
The competitive dynamic means substitute offerings. If a business model or offering is truly unique or has a defensible market position via geography like railroads or mental perceived value like impulse purchases of fast moving consumer product brands a firm may be able to extract higher margins.
Many competitive environments are relatively stable with the top 3-5 players holding 50-60% of market share and dictating price via competition between them.
It is like a horse race with most of the horses being about equal and extracting a median profit margin in the respective industry with some slight point of differentiation. If a horse nudges ahead with an innovation or advantage they may extract higher profits for awhile. The duration and scope of that advantage is their competitive moat. The moats success is measured by sustainable extra market profit margin.
Gum by gum
People paying an Extra $0.05 for a pack of $0.50 gum might just double the profits for a company in a 10% net margin business. If you don't believe you are brand conscious ask yourself, when was the last time you bought a generic piece of gum at the counter.
This competitive dynamic of limited shelf space at the check-out counter and a relatively non-innovative space means high margins for those 4-5 firms who can dominate the 3 foot battle field by the check out counter.
The latest innovative blister pack packaging was probably treated with serious anger when the first innovator put it in place. It meant everyone else would have to offer something competitive, spending capital and a dipping into margins until the costs were spread to the consumer at a new but accepted average price point for gum. The first mover had an edge for awhile with the new perceived value via the packaging borrowed from the pharma industry. Old wine into new bottles doesn't revolutionize the wine industry for long but means competitors have to keep up.
The real innovators dilemma: staying ahead
Innovators in a space have 2 challenges, they must create something new of value and be able to extract higher margins for the risks of failure. At the same time, depending on the innovation, innovators know that in many instances they are tipping their hand to their competitors who will replicate the innovation.
These horse races produce many winners over time, mostly consumers who see each unique horse, try out innovations of product, supply chain, brand, pricing etc. Each successful innovation leading to higher initial margins via happy paying customers gets extracted away by competitive replicators. This usually means most of the benefits end up with the consumer. That is how capitalism typically works assuming no collusion is in place. Positive externalities in the form of valued innovations are company led, but consumer driven.
The goal for a firm is to either have an innovation process for continuous advantage or an innovation that is so unique or protected it can't easily be replicated. Southwest airlines has a unique corporate culture that puts out a different vibe than one would anticipate from a price led competitor. Otherwise airlines are a horrible business with few sustained +10-15 year profitable margin firms. No moat equals business margin misery. Network hubs, airmiles etc. all proved to be false profits as they were replicable.
Some businesses have geographic moats, such as the short haul rail roads. They mostly compete with trucking instead of each other. This is an example of an asymmetric moat. Find the key component such as fuel, unions etc. that drive the relationship and you can understand the business and potential moat better. Most of it boils down to 2-3 key metrics.
As an investor, I am not interested in figuring out what is "hot" for earnings next quarter, but rather what might the next 3-9 years look like. This does limit the industries one can assess and it often means skipping the sexy sectors. High sustained margins may not always correlate with lots of media coverage.
The fun part of investing is figuring out what the moat is for each industry and competitor. The best businesses have multiple moats that all contribute to margin and are harder for others to replicate. Moats come in different shapes and forms.
A good value investor is really a good collector of mental moat models and the competitive positioning for each participant in a market. There are really only probably 20-25 key datapoints needed to understand a marketplace and all of its participants. Of course one needs the framework to put around the needle in the haystack.
Most Wall Street and popular analysis is about selling more haystack. Great ideas aren't sold by the pound. This fact means many miss the the effective and elegant thesis for the sake of the data heap. The nice thing about value is that often it moves slowly or the investor can choose an industry where it moves slowly.
Find the moat. Measure the Moat for its length (time) and depth (extra margin) and then you are one step closer to understanding value in the horse race of capitalism. Anybody can tell you price, few spend the time to understand value.
Here is the cartoon version with Warren Buffet and the Secret Millionaires club.
