Vilfredo Pareto is famous for unearthing the 80/20 rule, which suggests that 80% of a system's outputs or value usually comes from just 20% on the inputs.

If anything, the more connected nature of our world today has skewed Pareto’s distribution even further towards big winners. But like most economic theories, the specifics matter less than the broad idea. In this case, the idea being that a small number of outsized winners often dominate the overall outcome.

A handful of the world's biggest actors take home the lion's share of money earned by all actors. A small percentage of your Instagram posts – perhaps your wedding, graduation or baby pics – are repsonsible for most of the likes you've ever received. The S&P 500's biggest 100 firms represent around 75% of the overall market value. Et cetera.

The Pareto Principle is also visible in another area close to my heart: European soccer.

  • In Spain, Real Madrid and Barcelona account for around 70% of the male league championships ever won, and have lifted 35 of the last 40 between them.

  • In the Netherlands, AJAX, Feyenoord and PSV Eindhoven account for almost 90% of the league titles won since Dutch football went professional in 1954.

  • And in my home country, Celtic or Rangers have won over 85% of the league championships and every single one since 1985.

They are extreme examples. But they aren't outliers.

Almost every major European league has been dominated by just 3 or 4 clubs over the past 40 years.league-title-percentages

Source: League data and author's calculations

Unlike in elite American or Australian sport, these teams aren’t protected from relegation. If they were to have a nightmare season, they could go down to the lower league and not be able to win the top league for at least another year.

No, their positions of power aren’t the result of protectionism. Not until UEFA's new rules on Financial 'Fair Play' came in recently, anyway. Instead, they come from competitive advantages that, in most cases, have compounded over several decades.

Here's how that might happen: In the early days, a team’s city location or cultural links (a la Glasgow Celtic) bring bigger crowds. Bigger crowds bring more money, which can be invested in better players, better training facilities, better youth scouting systems. This leads to more on-field success and the wheel keeps turning.

More success, more fans, bigger commercial deals. More money, better players, more success. Once this cycle repeats a few times, the biggest clubs end up with a moat separating them from 95% of the country’s other clubs.

At Morningstar, we don’t analyse football teams. We study businesses and their investment potential. Our research process points to five main sources of moat:

  • cost advantages
  • intangible assets (like a brand)
  • efficient scale
  • switching costs
  • economies of scale

Of those, I think economies of scale and intangible assets are the most prevalent in football.

Through bigger commercial deals, more merch income and more TV money through participation in competitions like the Champions League, the top clubs earn a lot more revenue than smaller clubs. The gulf is especially big in smaller countries like The Netherlands and Scotland, where domestic TV rights are worth far less and only one or two clubs traditonally got to play in European competitions.

The top clubs in these countries can afford world-class training facilities and nationwide systems of talent scouts and youth coaches that smaller clubs can't. Along with the pull of being a big club, this ensures they attract the lion’s share of young talent. And if they fail to produce the best young players of tomorrow? They can just buy those produced by smaller clubs for an amount that means nothing to them.

Sometimes the big club genuinely wants the player to improve their team. Other times they just don’t want other teams to have them. It’s a bit like Facebook buying every start-up that breathed for a while. Some, like Instagram and WhatsApp, blossomed into star players. Others were killed off but served a purpose all the same.

The top football clubs also benefit from intangible assets – the heritage, cultural significance and entrenched fan bases that come with decades of past success. This leaves the elite clubs streets ahead when it comes to attracting fans, players, commercial deals and every other source of financial and on-field success. The only way around this is to have a bottomless pit of money like Man City. And even then, you can't buy the prestige of a Real Madrid.

The lamest prediction of all time

Next season, I think that one of Celtic or Rangers will win the Scottish league.

This is potentially the most boring prediction of all time. It’s also one that would probably earn me a negative return at the bookies because it’s so obvious.

When it comes to investing, though, this is exactly the kind of prediction that Warren Buffett recommends you stick to. As he says, "I don't try to jump over seven foot hurdles. I look for one foot hurdles I can step over". 

How, then, do you give yourself one-foot hurdles to clear?

I think that basing your predictions largely on things that have already happened is a good place to start.

My prediction for the destination of next year’s Scottish league championship is not based on my opinion of what players, management, transfers or tactics these clubs will have next season. It is not based on how strong or weak I think their competition will be. Instead, it is based on the underlying dynamics I know are already in place.

I am betting on the economies of scale. I am betting on the intangibles. I am betting on the system that brings about the result.

I think there are several ways to ‘bet on the system’ in business and investing.

  • I don’t know what the next TV smash hit will be. But I think there is a fairly good chance it will be a Netflix show. Their huge subscriber base allows them to justify a far higher production budget and number of projects than anyone else. They also have the biggest captive audience (until the next subscription renewal date, anyway) to promote new shows to.

  • I don’t know what the next big theme in workplace software will be. But I think Microsoft will probably be able to take advantage of it. The huge switching costs of moving away from Office buys them time to copy any major innovations. They literally took years to decide whether they would buy Slack or just make their own version (Teams).

  • I don’t know what the next big drug breakthrough will be. But I am confident it will be found, or at least commercialised, by one of the existing pharmaceutical majors. Nobody else has the huge cash flow or stomach needed to navigate the process of getting a new drug approved. Even if they did, nobody else has the entrenched sales relationships needed to turn trial approval into blockbuster sales.

In each case, I am relying more on something already in place (the competitive advantage) than something I hope will happen.

Of course, this does not mean that buying shares in the companies I have just mentioned is a good idea. You need to work out if the price of the shares is fair. And to do that, you do need to make some kind of prediction about the company’s future earnings.

Again, I think the best way to go about that is to start by focusing on the system you are relying on to produce those earnings – the company’s industry dynamics and competitive position – and how durable they are. As opposed to say, jumping in and saying earnings will grow at 7% per year because they have in the past.

I think this approach gives you a better chance of being roughly right rather than precisely wrong. Focusing first on the busness and moat can also give you the confidence needed to invest in quality companies when nobody else wants them.

As we know from market history, shares in high quality companies rarely become wildly undervalued. When they do, it is usually because investors are scared of something, the business has run into a problem, or there is a broader market slump.

The knowledge you have gained of the company’s business and competitive position can help you ascertain that the problem is temporary rather than a terminal issue. This could allow you to see the shares as offering good long-term value, even if the shares don’t look particularly cheap to others based on metrics like price-to-earnings.

To learn more about how to find companies with a durable competitive advantage, try this article by my colleague Mark LaMonica. And for a full checklist on how to think about valuing a share, take a look at this other article by Mark.

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