A high-quality compounder is a business that is highly profitable, has a strong competitive advantage (i.e. moat) and the ability grow (i.e. huge total addressable market). Companies such as Ferrari, Mastercard, Facebook, Berkshire, Amazon, Monster and Starbucks are great examples.
A key characteristic of a high-quality compounder is a high Return on Invested Capital (ROIC). The problem is that ROIC is a function of operating income and invested capital. For example, many high-growth companies spend heavily on marketing and R&D. Filtering by ROIC may cause you to miss many high-quality compounders.
A great solution to overcome this is to use the gross profitability as a first-level filter instead of ROIC. Professor Novy-Marx defines gross profitability as revenues minus cost of goods sold, measured against the book value of total assets. In other words, it measures the amount of gross profit a company generates for every dollar of assets.
Reasons gross profitability is a great filter
Gross profitability is highly persistent in both the short and long term. This allows investors to make a reasonable estimate of future profitability based on historical records. Research shows that businesses with higher gross profitability generally deliver better total shareholder returns.
Gross profits is the cleanest accounting measure of true economic profitability. The farther down the income statement one goes, the more ‘polluted’ profitability measures become. Gross profitability doesn’t ‘penalize’ companies for investing heavily in growth.
Many of the investments (largely marketing and R&D) that companies make for their long-term future growth can cause short-term hits to reported operating income.
A good gross profitability benchmark
So what is a good benchmark for gross profitability?
In Novy-Marx paper, gross profitability of 33% or higher is considered attractive. A look at Amazon’s gross profitability shows that it surpassed this level easily.
It is also worth noting that in Novy-Marx back-testing, a dollar invested in the market between 1973 to 2011 grew to over $80. While the same dollar invested in businesses that have high gross profitability (i.e. above 33%) grew to $572 in the same period.
Similar results were shown in a more recent study conducted in 2018 here. By investing in companies with high gross profitability of over 20%, it would produce returns in excess when compared to the overall market.
Conclusion
The gross profitability ratio is a great way to do a first-level filter. With growing revenue and gross profitability of over 20%, it is a great indication that the company could be a high-quality compounder which warrants further investigation.
In our future article, we will discuss in detail the issues with ROIC and how we may adjust the reported earnings figure to use this metric.
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Investors who held Mastercard for the past 10 years, have been rewarded handsomely with a 27.4% returns compounded annually. A $10,000 investment would have returned approximately $113,000 over this period. In this article, we will discuss why Mastercard’s wide moat has allowed it to reinvest its earnings at high returns.
In this post we will discuss Mastercard’s business model, reasons for their high margin, and why Mastercard will likely continue to grow and compound returns for its shareholders.
How Mastercard makes money
Mastercard does not see itself as a credit card company. Rather it sees itself as a technology company in the payment industry.
Taken from Mastercard’s 10K
Mastercard & Visa are commonly known as a tollbooth business. Before we begin, it is important to know who are the players in this space:
Account holder (That’s you and me)
Issuer’s Bank (Our bank)
Core Network (This is where Mastercard & Visa comes in)
Merchant (The store you buy your product from)
Acquirer’s Bank (The merchant’s bank)
Mastercard’s Business Model (Taken from Mastercard’s 10K)
Simply put, the role of Mastercard is to be the bridge between our bank and the merchant’s bank. While doing that, they collect a small fee of approximately 0.25% on the transaction. For example, when you buy your iPhone for $2,000, Mastercard will make $5 from the transaction.
The beauty of Mastercard business model is that it does not assume credit risk nor does it have to deal with end-users like us. It merely sits as a connecting network for the banks and collects a small fee.
Taken from Mastercard’s 10K
The company makes the bulk of its revenue by mainly charging a small percentage of the transaction and a fixed fee per transaction.
Some of the key metrics investors should track to measure if Mastercard’s business performance and moat would be:
Gross Dollar Volume (GDV) – How much we as consumers spend using a Mastercard in total.
Cross-border volume growth – The increase in consumers spending overseas.
Switched transactions – Number of transactions processed.
Number of cards issued
(Rebates + incentives)/Revenue – This is the amount Mastercard spends to attract financial institutions to carry its brand. An increasing ratio may mean the industry is getting competitive.
Rational competition
Industries that are dominated by a few key players (duopolies or oligopolies) often act like monopolies. Tacit collusion is normal and competition is rational, as industry players raise prices in tandem and compete for the share of the market. This “cooperative behaviour” allows companies to generate sustained high returns on capital.
“A basic industry with few players, rational management, barriers to entry, a lack of exit barriers and noncomplex rules of engagement is the perfect setting for companies to engage in cooperative behavior…and it is for this reason that the really juicy investment returns are to be found in industries which are evolving to this state.”
Marathon Asset Management
As a connecting network, Mastercard is effectively a duopoly with Visa. We can see that Mastercard has been able to hold their fees steady over the years as we can see from the crude take-rate (obtained by Revenue/GDV).
Mastercard’s Rising Take-rate
And this has translated into fantastic margins for Mastercard. Their gross margins are 100% as there are no variable costs associated with every transaction. With GDV and revenue growing at a fast clip as shown in the table above, Mastercard is able to spend its gross profits on marketing, R&D and the likes to expand its moat.
Their operating margins have consistently been above ~50% for the past decade. Except for its closest competitor Visa, there probably isn’t another company that is able to consistently generate such high operating margins.
Network effect
When it comes to an economic moat, there may be none stronger than a network effect once it has been set in motion. The idea is simple, as more customers carry a Mastercard, more merchants would accept Mastercard, which would then drive even more customers to own a Mastercard.
Over the years, we have seen this played out beautiful as the number of cards issued and merchants on-boarding grow. At of 2019, there’s approximately 2.2 billion Mastercard issued around the world.
Compounding machine
The characteristics of a compounding machine are: (1) Ability to generate high returns on capital in cash; and a (2) Long runway for growth. Let’s see how Mastercard fare in this aspect.
(1) Ability to generate High ROIC in cash
Over the past 5 years, Mastercard’s Return On Invested Capital (ROIC) has an average of approximately 60%. To put this in perspective, the average ROIC of the S&P500 companies hovers between 9% to 13%. As a quick rule of thumb, we typically want to look for at least a sustainable 20% ROIC.
Having a ROIC of 60% means that every dollar of retained earnings will generate an additional $0.60 of earnings.
Over a 5 year period, the company’s cash conversion is also above 100%. This means that every dollar in earnings translates to more than a dollar in cash.
Over the last 3 years, the company generated $20.1 billion of operating cash flow. And returned $18.4 billion to shareholders through share buybacks and dividends.
Mastercard is able to do so because it is a capital-light business that doesn’t require huge investments; freeing up plenty of cash for shareholders’ benefit.
(2) Long Runway for Growth due to Cashless trend
Without room to grow, a high return on invested capital alone would not generate wealth for investors. So let’s take a look at what makes Mastercard a compelling investment.
The company processed a gross dollar volume of $6.5 trillion in 2019, which seems already immense. However, the Total Addressable Market (TAM) size for payments is $235 trillion! And cash payment still accounts for 85% of transactions. The trend of moving towards a cashless society remains a powerful propeller for Mastercard’s growth.
This is especially so when an estimated $68 trillion of total payment (~30%) is still made in cash & check. In light of COVID-19, it will likely accelerate the trend of declining cash usage and hasten the change in consumer behavior towards cashless transactions.
In Mastercard’s latest research, contactless payment grew twice as fast as cash payment as consumers are concern about the spread of germs. Likewise, with social distancing in place, many are turning towards e-commerce for their shopping needs. This could potentially be a long-term consumer behavioral change in Mastercard’s favor.
Risk: Fast-changing landscape
The payment industry is a fast-changing one. In recent years with online transactions accelerating, we have seen the growth of payment aggregators such as Adyen and Stripe. And even more recently, we have seen Square threatening to take over the offline transactions. These payment aggregators threaten to take over the acquirers slice of the pie.
However, they are still reliant on payment networks and their technology is built on top of Visa’s and Mastercard’s technology. The real threat would come if Stripe venture into personal banking solutions and achieve huge success. Imagine using Stripe to store your savings and to process your online transactions, skipping the card network altogether.
That would be similar to what Alipay and Wechat Pay has achieved in China, with so many users on their network they are able to bypass the card networks altogether.
This still seems quite far-fetch for the players outside of China. And would likely trigger anti-trust lawsuits if a player becomes as dominant as Alipay or WeChat Pay. To achieve this dominance and bypass the card networks, everyone must be using Stripe’s credit card and bank account.
All-in-all, Mastercard is a company with a fantastic moat and a capital-light business. Though the fintech and payment industry is a fast-evolving one, understanding the dynamics would allow us to observe that these card networks are likely to retain its dominance for years to come.
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How Ferrari delivered outsized returns for investors with its economic moat
“The most important thing [is] trying to find a business with a wide and long-lasting moat around it … protecting a terrific economic castle with an honest lord in charge of the castle,”
Warren E. Buffett
An economic moat is a term popularized by Warren Buffett, as he drew references to how business is like a castle, and having a strong moat is essential to deter invaders. Buffett invests in businesses that have a sustainable competitive advantage to protect themselves against competitors eyeing a slice of the market share.
Why should investors care about a company’s economic moat? The answer can be explained by the economic theory, mean reversion. Most of the time, investors & forecasters have a tendency to extrapolate the current trend. Companies that previously generated high growth are forecasted to continuously generate a high return and vice versa.
In reality, high returns will likely revert to the mean. Mean reversion is like gravity to returns on capital. An industry becomes attractive when incumbents generate high-returns on capital, enticing competitors to enter. New entrants will compete for market share, driving returns down for the incumbents.
Without a strong economic moat, high returns on capital would not be sustainable. Familiar examples that illustrate this trend in Singapore would be bubble tea, yogurt ice cream, poke/acai bowl, fried salted egg chips, etc.. you get the point. Without a moat, the success of these trendy concepts will attract competitors to pop up and reduce the incumbents’ profitability.
The outliers
That being said, there are companies that have defied mean reversion and continued to generate high returns on capital (in excess of 20%) for investors throughout the years. Some examples that spring to mind include Hermès, Costco, Facebook, Coca-Cola, and Illumina.
“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
Warren E. Buffett
A company’s moat is either expanding or declining, it never stays stagnant. As investors, it is our job to determine if the business has a sustainable moat and evaluate if management continues to invest in growing the moat. Popularized by Pat Dorsey, moats can be classified into the following categories: (1) Strong brands, (2) Patents or licenses, (3) Network effect, (4) Low-cost producer, and (5) High switching cost.
A strong brand name
“It’s not Christmas or New Year until you see Coca-Cola ads.” Or so the saying goes. Occupying a share of consumer minds is no easy feat. Brands such as Coca-Cola, Ferrari, Hermes, and Tiffany & Co brands have been extremely successful in occupying a share of our minds, allowing them to earn a much higher return than their competitors.
At the risk of this article becoming too long, we will discuss 1 of the 5 moats in this writing. Specifically, Ferarri (ticker: RACE) and how its strong branding has allowed investors to generate outsized returns over the years.
The birth of automobiles
Ever since the first introduction of cars in 1886, more than 2,000 carmakers have attempted to penetrate the market and most of them have ceased to exist. The automobile industry is notoriously competitive and capital intensive, companies often have to rely heavily on debt. Furthermore, it is also an extremely cyclical industry, where demand will taper off sharply (especially during times like these) as consumers will defer the decision to purchase a new vehicle when times are tough.
As a result, most carmakers have lumpy earnings and many generate negative Free Cash Flow (FCF). Making survival in this industry very challenging. As an example, General Motors (GM) generated a cumulative negative FCF of -$50.9billionover the last 5 years. And they have made up for this shortfall by aggressively piling on debt to survive.
“What you really should have done in 1905 or so, when you saw what was going to happen with the auto is you should have gone short horses. There were 20 million horses in 1900 and there’s about 4 million now (the year 2001). So it’s easy to figure out the losers, the loser is the horse. But the winner is the auto overall. 2000 companies (carmakers) just about failed.“
Warren E. Buffett
The bright red car
Amidst the pack of car markers, Ferrari has the ability to charge astronomical prices for their vehicles. The power of the Ferrari brand is clearly evident here in Singapore. Despite our stringent speed limits and countless traffic lights, drivers still own Ferrari because the brand signifies wealth and affluence.
Ferrari’s moat allows it to earn outsized returns against other carmakers. The company has consistently commanded an average of 50% gross margins, while its competitors languish at an average of 15% gross margins.
In other words, the car which costs $50,000 to make can be sold at $100,000 for Ferrari. Its competitors, on the other hand, produce cars at the same cost of $50,000 but are only able to charge $59,000.
The fat margin leaves a lot of room for Ferrari to invest in widening its moat (e.g. invest in R&D and marketing) or to reward its shareholders.
Taking a look at their pricing power, Ferrari is able to command € 381,474 (SGD 588,000) per car on average. Competitors such as Ford and GM are only able to charge a fraction at $25,000 (SGD 35,600) and $16,000 (SGD 22,800) per car on average respectively.
Ferrari’s Cars Sold and Revenue per car
During the 2008-09 global financial crisis, we saw the United States’ new car sales plummeted by 40%, sending GM and Chrysler into bankruptcy while Ford had to take a substantial loan from the government to stay afloat.
Car sales fell across the board for most carmakers, except for the company that made the bright red car. Despite the industry buckling down, Ferrari managed to see a 26% jump in the U.S. with its vehicles sold increasing to 6,587 in 2008, an increase of 122 from the previous year. And during 2019, it only saw a 1% decline in revenue.
The brand of Ferrari is so strong that its revenue growth continues to stay resilient through crises such as the 2008-09 financial crisis, Europe debt crisis, and trade war.
It targets the ultra-rich, and the company produces a limited number of cars each year. The long waiting list of up to 2 years, created a real sense of exclusivity for customers who can get hold of one. Even if customers have the cash to purchase a new vehicle, there is a limited quantity. This discourages those on the waiting list from withdrawing their orders even during bad times. And even if they do drop out, there is a long list of customers to take up their spot!
The moat surrounded Ferrari has proven to benefit investors immensely. Since its spin-off in 2016, it has delivered a CAGR of 37.3%, delivering a 400% return prior to Covid-19 within a short span of 4 years. Comparing this result with Ford, GM, or even the S&P 500, Ferrari has generated astounding returns for its investors.
To sum it up, having a strong brand that occupies a large share of consumer’s minds is a great moat, enabling companies to sustainably generate high returns on capital. As investors of quality compounders, we need to monitor if management is engaging in activities that widen the moat. Such as spending on marketing, increasing customers’ satisfaction, etc.
