Welcome back to Part 2 of the Value Creation series. If you haven’t checked out Part 1, then check it out and meet me here again. To provide a brief background, I’ll check I The four key points of Professor Aswath Damodaran how companies can create value for shareholders.
In Part 1 I discussed the first two points:
- Change cash flows from existing assets
- Increase in value through expected growth
We looked at how companies like eBay created shareholder value by spinning off a more successful company, PayPal. We then analyzed how much value the introduction of the iPhone offered to Apple shareholders, as well as key M&A activities Disney conducted in the 2000s that brought tremendous returns for shareholders.
Without further ado, we come to the third point.
3. Extension of the growth phase by creating or strengthening competitive advantages
Build on existing competitive advantages
The greatest strength of many companies is simply their brand name. Coca-Cola is the first business that comes to mind here. In fact, as the first example that came to mind, the brand already proves just how strong the brand name really is. Some brands are so popular in our minds that they actually dominate the identity of the product.
- Kleenex = handkerchiefs
- Plasters = bandages
- Google = web search
- Lipstick = lip balm
- Post-it = sticky note
- Cola = sweet soda drink (at least for everyone in the south)
And the list goes on and on. But like empires, strong brands aren’t built in a day. It takes you decades of marketing and advertising to get to this point. Not to mention the obvious factor: The product has to be great.
After an amazing brand is created, it needs to be defended. Sometimes defending a brand can be more difficult than creating one. Staying top dog in people’s minds isn’t an easy thing, as many marketers are sure to tell you.
Good management in a company knows that it should do everything possible to protect the brand that pays its wages. Let’s use Coca-Cola as an example.
In the past few decades, the Coca-Cola company has been criticized in some outlets for making a rather unhealthy drink. Their drinks have been linked to terrible diseases such as obesity and diabetes; but that’s not exactly groundbreaking news.
That controversy, however, by and large did not affect the company. Coca-Cola is a well-diversified company at this point in the corporate life cycle and owns many beverage brands, some of which are “healthier” options.
Plus, the brand is so powerful at this point that it’s almost too big to fail. Coca-Cola has done an excellent job promoting their brand in connection with good times and joy. So good that it accounts for almost 80% of the company’s profits probably from the brand name alone!
Because who doesn’t want a sweet drink now and then?
Find new competitive advantages
Imagine if I just told you that your bank was magically foreclosed and you had to move to a new institution. How big would the pain be?
You would have to open a new account with a new bank, transfer all of your money to that new account, check with HR at work to make sure your direct deposit goes to the new account, get a new debit card … me think you understand.
Certain banks, insurance companies and other financial institutions benefit from the switching cost advantage. Nobody enjoys opening new accounts and talking to more people!
Companies that understand this phenomenon will benefit from trying to implement it into their business model. For this to work, you want the barrier to entry low but the barrier to exit painful. This is difficult, but it can be achieved using either of the following two business models:
- Decent business: offering an annoyingly necessary product
- Best Business: Offer a sticky product that cannot be found anywhere else
The decent companies are the ones that offer must-have products that are a hassle to leave because of the fees. Think about your monthly recurring payments (either incoming or outgoing): insurance, banking, cable / internet, etc. These companies offer supplies, usually with contractual obligations. They make it a colossal pain to switch to another service for those just trying to save $ 20 a month.
It’s best to stay with them instead of paying the cancellation fee.
The best companies are those that offer a sticky product that cannot be found anywhere else. These are usually technology companies that offer subscription business models. Think of products like Adobe, Autodesk or even Microsoft Office. These are all fantastic products that are widely available and used in many businesses / governments and are not easy to replicate.
All of these companies had previously offered their product as a one-time purchase. However, they quickly realized that the ability to retain their customers for a low monthly fee would create more stable revenue streams, and therefore more value for shareholders.
Having a sticky product with recurring revenue is a far better option for both consumers and shareholders.
Companies that find a way to keep their costs below those of their competitors will always be more beneficial to customers. The aim here is to reduce costs, but at the same time generate free cash flow.
This usually means that the company has pricing power over its competitors. This is what makes or breaks raw materials companies.
Here is an example:
If you run an oil rig that costs only $ 30 to drill a barrel of oil, but all of your competitors pay $ 50 to drill it, you have a $ 20 cost advantage over them. That benefit becomes even more apparent if the price per barrel were to drop to $ 40.
With the cost advantage, your business would still be making a profit while your competitors struggle to cut costs or run into debt.
The aim here is to gain the cost advantage and maintain it for as long as possible. This can lead to predatory pricing wars, but in the end, if your business can be the lowest cost producer, you will be the only one left.
4. Lowering the cost of capital
Reduce the operational risk of investments / assets
If a particular department or department of a company can be effectively outsourced (with no moral hazard), why not? Effective outsourcing can allow companies to focus on what they do best and outsource the rest to someone else who does it better.
Reducing or eliminating debt is a surefire way to increase shareholder value. When a company goes bankrupt, the pledges are the first to get their money back, not the shareholders.
By deducting the debt, it means that your property is much bigger. Personally, I prefer to look at companies with no net debt as it just means that the company is a far less risky bet.
Flexible wage and cost structure
COVID forced many of us to work from home, or at least use a hybrid model. This should be the norm for most companies in the future.
Both companies and employees benefit from flexible working. Companies will need less office space, which will lower real estate costs. The employee benefits from not having to commute to work every morning and coming to work in pajamas all day!
This new work structure will most likely result in companies and employees becoming more involved in the gig economy. This enables companies to offer their employees more flexible salary or payment options.
I firmly believe that the new remote / hybrid work environment will benefit almost everyone. But the main benefactor is one you probably haven’t even thought of: the environment.
Think about it. Fewer cars commuting to work every day will avoid a lot of traffic and pollution. Less office space in urban areas means we can build more parks and green spaces to invigorate our environment.
Improvement of current products
Make the product or service less discreet
I can imagine a product that has gone from being barely used to becoming widespread over the past 20 years: the mobile phone.
Not only did cell phones become the norm, we also quickly created new innovations on cell phones by turning them into smartphones. 20 years ago you really didn’t need a cell phone. You could come around doing things well without it.
Fast forward to today and I can barely function without my cell phone. I use it for directions, music, reading, texting, etc. This widespread adoption of the technology has benefited many companies in many industries; Telecommunications giants like Verizon and AT&T, phone manufacturers like Apple, semiconductor companies for the processors, the list goes on.
Change product properties
Making a product more user-friendly will only delight customers. Simply upgrading a product to a new model or just a more appealing look can increase sales.
More effective advertising
As mentioned earlier, marketing and advertising are huge investments for many companies. Establishing a new marketing campaign can breathe new life into a brand or product.
Do you remember a few years back when IHOP announced that they were going to change their name to IHOB?
This stunt set the internet up in flames. It obviously didn’t actually happen, but this campaign actually resulted in renewed attention for IHOP and increased revenue for a while.
Change the funding composition
Match debt with assets
Typically, companies operate with a “normal” debt-to-asset ratio. Sometimes they can be above or below their goal. With a simple adjustment, management can create more value for shareholders.
For example, there is a company that currently has no debt but typically operates with a D / A ratio of 0.5. Let’s say this company wants to buy another company but doesn’t have enough cash.
Since the company currently has no debt and typically operates at a 0.5 D / A level, this could add some leverage to the acquisition.
Finding quality companies to invest in is important. More importantly, understand how this company can add value to your investment.
If a company has been able to create value over and over again year after year, that is a sign of a quality compounder that you should investigate further. Many of these companies are well known and full price so the hardest part (for me anyway) is maintaining valuation discipline.