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Why so many narrow moat companies with high market share?


scorpioncapital
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I see several narrow moat companies (at least as defined by Morningstar) with very high market share. Why does this happen? Say Vmware. There are several huge and smaller competitors. Is it just a temporary switching cost issue?

 

Also some companies in biological lab equipment, reagents, genetic sequencing (e.g. Ilmn). None of them are making anything that can't really be produced by anyone else. Why do competitors have trouble making inroads in such situations or is it just "a matter of time"

 

 

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Will try to go from micro to macro and back and this thread reminds me of one you started recently which dealt with the issue from a regulatory angle.

 

I just arrived at a conference where the title includes "dynamic" and "staying ahead" but even if the title is elegant, it's really about maintaining regulatory capture.

 

There are many reasons/causes but I think this has to do with the fact that we live in a golden era for incumbents (section 4, starts page 23).

https://eig.org/wp-content/uploads/2017/02/Dynamism-in-Retreat.pdf

 

An interesting area is that we seem to take for granted that financing is easy (financing is important for entrants) but it appears that financing for smaller players is nothing but easy. One way to gain market share is to be at the leading edge; stifling entrants may help. And I wonder if the Great Recession was not a wasted opportunity.

 

At lunch, I'm sure somebody will take a photo of their meal and send it to "friends" but somehow it seems that the real issues will not have been discussed.

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Have you ever been involved in the process of acquiring one of these products you mention?  My experience has been that you are under tremendous pressure to get it right, you don't have adequate time to compare and you have other responsibilities.  So if prices are at all comparable, it is so tempting to go with one of the larger competitors.

 

I also think that a narrow moat is still a moat, they are still advantaged. Once you have market share you have significant operating leverage over your competitors.  It's really hard for them to compete.  They have higher costs and less reputation.

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I see several narrow moat companies (at least as defined by Morningstar) with very high market share. Why does this happen? Say Vmware. There are several huge and smaller competitors. Is it just a temporary switching cost issue?

 

Also some companies in biological lab equipment, reagents, genetic sequencing (e.g. Ilmn). None of them are making anything that can't really be produced by anyone else. Why do competitors have trouble making inroads in such situations or is it just "a matter of time"

 

Because the high market share Is the moat. I know it’s sort of a circular answer.

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ScorpionCapital,

 

Your question is a very wise one. Such companies are wide-moat, not narrow-moat (though someone like Morningstar may see things differently).

 

There are a very limited number of people with the specialized skills to build these products. And it takes years to build them even with those specialized skills. Someone who has a large amount of financing would have to still be able to hire away employees en-masse. It is the accumulated talent and experience that gives them the moat. You might have cases where no college grads have entered that field for 10-15 years because they have been lured somewhere else.

 

For people who work in the same industry, it is easy to see which moats are wide and which aren't (i.e.. they track where their former classmates and colleagues are working, watercooler conversations).

 

For people who don't work in that industry, GAAP profits are a good indicator of moats. This raises the question - why do VMW and NOW have almost the same market cap. VMW's FCF is almost the same as NOW's revenue. They say VMW is an on-prem company and is getting bypassed due to the move to the cloud. Yeah, but my reply is would NOW ever be able to make a GAAP profit to justify its $56 B market cap? They are an app on AWS, and the number of AWS app companies are in the hundreds. High-tech wide-moat companies should not have any trouble showing GAAP profits.

 

It is kind of like the negative-yielding debt. The momentum is the only justification for a while. A bond is supposed to pay interest, stocks are supposed to show a profit (at least eventually). $17T of -ve debt suddenly went to $12T of -ve debt, can't hear even a whimper from Draghi-loving FT.

 

Also, such specialized skills employees do get hired away by cloud companies like Amazon, Microsoft, Google. They bypass VMW by changing lanes to the cloud (i.e. attack from a different angle). Around 10 years ago VMW debated whether or not they should build their own cloud, and elected not to.

 

BTW, I am not invested in VMW currently.

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I see several narrow moat companies (at least as defined by Morningstar) with very high market share. Why does this happen? Say Vmware. There are several huge and smaller competitors. Is it just a temporary switching cost issue?

 

Also some companies in biological lab equipment, reagents, genetic sequencing (e.g. Ilmn). None of them are making anything that can't really be produced by anyone else. Why do competitors have trouble making inroads in such situations or is it just "a matter of time"

 

Because the high market share Is the moat. I know it’s sort of a circular answer.

 

VMW might be toast longer term (let's discuss on VMW thread though). It did have a huge first-mover advantage, great (way better than others) tech, real switching costs, and a real moat through now though.

 

I think ILMN also has a large first mover advantage and possibly better tech than competition and likely switching costs. But I know that area way less than VMW.

 

Like others said, "narrow moat" is still moat. And large market share may lead to some moat (of network effect, switching costs, low cost provider, etc.).

 

And getting capital for head-on competition is very tough. Getting capital for something that is different and may displace the incumbent by a side swipe is possible and easier though. So no guarantees for long term.

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There are some product areas where there are at most 2 or 3 teams in the entire country that can build a quality product. For example, no college grads have entered operating systems related areas since the Google IPO 15 years ago, they have all gone into Big Data and AI.

 

Right now capital is unlimited (e.g. Gusto just raised $200 million Series D for head-on with WDAY).

 

But you can't find the teams to build certain products, another example would be networking products - routers/switches. In such areas you find high GAAP profitability and dividends because competition is limited.

 

These are very tricky times. We have a whole generation that hasn't seen a bust, the bull market is closing in on 11 years.

 

 

I see several narrow moat companies (at least as defined by Morningstar) with very high market share. Why does this happen? Say Vmware. There are several huge and smaller competitors. Is it just a temporary switching cost issue?

 

Also some companies in biological lab equipment, reagents, genetic sequencing (e.g. Ilmn). None of them are making anything that can't really be produced by anyone else. Why do competitors have trouble making inroads in such situations or is it just "a matter of time"

 

Because the high market share Is the moat. I know it’s sort of a circular answer.

 

VMW might be toast longer term (let's discuss on VMW thread though). It did have a huge first-mover advantage, great (way better than others) tech, real switching costs, and a real moat through now though.

 

I think ILMN also has a large first mover advantage and possibly better tech than competition and likely switching costs. But I know that area way less than VMW.

 

Like others said, "narrow moat" is still moat. And large market share may lead to some moat (of network effect, switching costs, low cost provider, etc.).

 

And getting capital for head-on competition is very tough. Getting capital for something that is different and may displace the incumbent by a side swipe is possible and easier though. So no guarantees for long term.

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My current employer uses Gusto instead of Workday - it is faster and cheaper and better. I have an analogy for unprofitable SaaS companies like WDAY.

 

Suppose you have a great office building in a great location (your capital). You lease your building for eternity to a tenant who will never pay rent. Your only option is to sell it to someone else who hopes to extract rent - but that day never comes.

 

But what if the office building gets sold and re-sold year after year at ever higher prices without seeing a single rent check.

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Guest cherzeca

just a thought:  I know someone that works at a SaaS company where it is the dominant company in an admittedly small space but where there are really no tech barriers to entry.  he works at providing great service, high touch, calling in to check up etc.  no reason for customers to switch if they are well serviced

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Yeah, no reason to make profit either because the high-touch customer service costs money. These people providing the great customer service are also paid partly in stock and a rising stock price boosts their morale.

 

It is like an office building whose tenant won't pay rent and cannot be evicted. Their survival depends on not being required to pay rent.

 

On the other hand we have a company like CSCO that trades at EV/FCF of 12, yields 3.1%, guaranteed to be powerful 20 years from now with very high barriers to entry. Barrons's dumped CSCO this weekend in their cloud article even though there is no alternative in networking and won't be either.

 

just a thought:  I know someone that works at a SaaS company where it is the dominant company in an admittedly small space but where there are really no tech barriers to entry.  he works at providing great service, high touch, calling in to check up etc.  no reason for customers to switch if they are well serviced

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just a thought:  I know someone that works at a SaaS company where it is the dominant company in an admittedly small space but where there are really no tech barriers to entry.  he works at providing great service, high touch, calling in to check up etc.  no reason for customers to switch if they are well serviced

 

Well, there is switching cost. The more folks work with the company and the more embedded it is in business processes, the higher the switching cost and risk.

 

I do wonder though they with the virtually zero unit cost models, like SAAS, that when times get tougher, the price may become a tool to acquire or retain customers at some point, especially if there are equivalent competing products around. After all, why wouldn’t a SAAS company not use price as a tool if they have to, since the incremental unit cost is zero. So it’s just a question if the product has substitutes or not.

 

The company I work for just introduced WDAY. I think it replaces an SAP module that was awful. I will see how this goes. So far it looks like the conversion has been botched, the go live is at least one month late and counting.

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Guest cherzeca

"It is like an office building whose tenant won't pay rent and cannot be evicted. Their survival depends on not being required to pay rent."

 

this sounds like a great deal....what/where on earth are you talking about?

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Guest cherzeca

" So it’s just a question if the product has substitutes or not."

 

the product has substitutes but the service (including training) is apparently more important.

 

just saying that good service implies a switching cost risk that is hard for customer to quantify...alternative's unit cost can be quantified but what is the cost of having your currently happy employees relearn a new process and leave a support system that they are pleased with

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If the technological barrier to entry is small, there will be more competitors like we have in the case of WDAY. Whenever GAAP profits and dividends are missing, it is almost always the case that the technological barrier is small.

 

My previous three employers used WDAY, but the current one uses Gusto. Gusto is faster, sleeker, and cheaper.

 

Is this another case of permanent capital loss in the case of WDAY, did the Greater Fool Theory stop working or will it revive again? Things like service, sweet-talking salesmen, zero unit cost are not barriers to entry when competitors have access to the same things.

 

WDAY peaked at $225 in July, today it is at $165.

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The last time I invested in oil companies was 2006-2008, i have no insights into oil. I concluded that oil prices are unpredictable and have stayed away ever since. Buffett himself got it wrong in a big way in 2008, he bought COP around the oil price peak and then it crashed.

 

What would you say is the technological barrier to oil extraction? is there a way to determine if a technology is easy or difficult to utilize?

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I know some companies that have (still) decent margins in a competitive field because they use employees in cheaper countries so when cost inflation kicks in it does't harm them as much. I suspect of course everyone is outsourcing but some maybe can outsource in places others cannot. I have had friends and relatives ask me a very innocent question I could not answer: So what if there is competition. What's wrong with a company making money making a product or service in a slow and steady sort of way? Of course I agree , especially if a low price is paid as an investor, but for example why do some great investors insist on being so picky with 'superior' businesses. One might be picky to not pick companies that make no money, or will make very little in time for the price paid but other than that, is low moat or no moat businesses so disastrous to your financial health?

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So what if there is competition. What's wrong with a company making money making a product or service in a slow and steady sort of way? Of course I agree , especially if a low price is paid as an investor, but for example why do some great investors insist on being so picky with 'superior' businesses. One might be picky to not pick companies that make no money, or will make very little in time for the price paid but other than that, is low moat or no moat businesses so disastrous to your financial health?

 

I think the issue here is predictability. In a more competitive market, one cannot assume that all participants will price rationally.  So, if you buy a company without a moat, who's to say that profits will even be there in a year?  Plus, companies have natural operating leverage, so if you have low margins, a minor reduction in expenses by a competitor leading to a minor reduction in pricing could completely wipe out all your profit, leavin you in a loss position. Or, they could take away enough of your economies of scale to cause a death spiral.  There's just a lot more variance in the future results.

 

So, if you value the company based on discounted cash flow over, say, a decade or two, but can't have any confidence in that cash flow beyond the next year, how do you value that company?

 

Plus, I think historically, an inefficiency of securities pricing is that investors were willing to pay more for present day earnings than a strong moat that enables future earnings, so strong moat companies were often undervalued. The way you can see this is to compare the value of a company with a moat, where future earnings might need to be discounted at 15% with the value of a company with a strong moat where future earnings might need to be 5%.  Often, the difference in those discount rates won't actually be reflected in the security prices. What's more, even if the securities are priced fairly, the 15% case is likely to have much higher variance in outcomes meaning more diversification (i.e. smaller position sizes, more research, and more expenses) is necessary.

 

All this implies that one should generally prefer superior companies.

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