TRIBUNE by Cedric Bourdy, head of Distribution, Nevastar Finance Luxembourg. Commentary sponsored by Nevastar Finance.
'Economic moat' is a term first popularized by Warren Buffett in the 1990s, which refers to a company's ability to maintain a competitive advantage over its competitors. The term is now widely used by the asset management industry and helps the manager make investment decisions. At Nevastar Finance, in our NSF Wealth Defender fund, we invest in companies with a wide economic moat.
This means that companies that can maintain these competitive advantages over the long term have pricing power, sustainable profit growth and strong cash generation; they are resilient businesses, with high returns on capital, that are able to generate value regardless of the economic environment. They can weather all macroeconomic environments and increase their prices throughout economic cycles.
As Warren Buffett once said, "The most important decision in evaluating a business is pricing power. If you have the power to raise prices without losing business to a competitor, you have a very good business. And if you have to say a prayer before you raise the price a penny, then you have a terrible business."
When assessing whether a company has a wide economic moat and pricing power as such, from our point of view the following competitive advantages are observed:
- Intangible assets: these can be patents, trademarks, licenses, etc. that can be very difficult to replicate and prevent other companies from producing the same product. These intangible assets allow companies to charge a significant premium on their prices and exercise their pricing power. Over 90% of the world's population would recognize the Coca Cola logo if it were shown to them, that's enormous branding power. Another example might be Disney.
- The network effect: the level of service or added value of a product increases as more people use it. The perfect example is social networks or e-commerce platforms, which provide more value to users as the number of people, buyers or sellers using them increases. Because the value proposition of the product improves as the number of users increases, a virtuous circle is created in which existing users encourage others to join, which improves the value of the product, and so on. Most large technology companies have built their value-add on the network effect, and it is very difficult for competitors or newcomers to create as much value for users, as they are latecomers and have fewer users.
- Cost leadership advantage: when a company is able to sell the same product as the competition but at a lower price thanks to economies of scale and lower cost of production. Walmart and Costco are leaders in low-cost strategies and are able to offer lower prices for their products thanks to their size, economies of scale and their power to negotiate lower prices with suppliers.
- High switching costs: some products are so integrated into our lives that we cannot imagine doing without them or changing them would be very costly and/or time consuming. For example, companies that use Microsoft's environment, or Amazon for their cloud platform and services, will find it very difficult to switch vendors. The public using some Apple products (phones, tablets, Mac laptops, iwatches, the Apple cloud, etc.) would have a hard time switching everything. Another example is software, which requires specific training and skills to be used by company staff, so it is a very recurring revenue business where it is complicated to replace, once installed and knowledge is acquired, so customer retention rates are very high.
With today's high inflation rates, rising cost of goods, labor and manufacturing, companies with pricing power will be able to pass these cost increases on to their customers without losing market share. Companies without pricing power will see their margins fall and become less profitable.
Indeed, pricing power demonstrates its true value in an inflationary environment, and its beneficial effects accrue the longer it lasts. In the face of entrenched inflationary pressures, those firms with established competitive advantages and the ability to pass on price increases to customers are likely to be able to maintain their competitive advantages.
These are some examples of companies with competitive advantages that are exercising their pricing power:
- Apple increased the price of its iPhone offering by 30% in the last 5 years, with no loss of market share.
- Microsoft has continually raised the price of its Windows and Cloud operating system. Software is immune to supply chain risk, and the recurring revenue model of subscription-based software is easily indexable to inflation.
- Disney World ticket prices have increased 6.5% year-over-year since 1971 (versus an inflation rate of 2.2%).
- Luxury brands, such as LVMH, have been able to steadily increase their prices (a recent example of this is the increase of LVMH handbag prices by 20% in 2022), and yet LVMH still managed to post record sales at the same time.
In terms of diversification, many fund managers hold too many stocks. At Nevastar, we want to invest in the companies in which we have the greatest conviction with sufficient diversification. We believe that with 29 stocks, idiosyncratic risk is avoided. The companies held in the fund are global. Its investment universe is focused on capturing opportunities in the fastest growing parts of the world. Although many of them are U.S.-listed, they are highly diversified geographically by revenue. In addition, exposure to the U.S. is similar to the world indexes.
Our technology allocation can range from 25% to 45%. When it comes to competitive advantage and pricing power, we see a lot of value in the technology sector, where innovation brings differentiation and changing demand can be met quickly. Technology innovation has been the main source of growth over the last decade, and is likely to remain so in the coming years.
The technology stocks held within the fund remain highly profitable cash generative businesses that are not as sensitive to rising interest rates due to their low debt and inflationary environment as other unprofitable, cash-burning businesses that tend to characterize smaller technology companies. In conclusion, the NSF Wealth Defender fund is invested at all times in those companies in which one wants to remain invested in the future and which will protect the long-term wealth of its investors.