Mark Lamonica: Welcome to Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into account your personal situation, circumstances or needs. So today we're going to explore two different M word Shani that are related to investing and I know I perpetually disappoint you, but neither of them are managed funds. 

Shani Jayamanne: Is this a guessing game?

Lamonica: Yeah, go for it mate.

Jayamanne: Alright. Morningstar, money.

Lamonica: No.

Jayamanne: M&A.

Lamonica: M&A, no, no. And those are strange combinations. Are you trying to say that Morningstar is going to be purchased or purchase something?

Jayamanne: Yeah, don't read too much into it. Or maybe do.

Lamonica: Wow. Shani is on the inside. She's in the know. But yeah, anyway, let's not make the whole episode a guessing game, Shani. So I can just come out and say it.

Jayamanne: What about money market account?

Lamonica: It is also not money market account. The two M words Shani, are margin and moat and they're both related.

Jayamanne: Okay. Well I think my guesses would have made for a much more exciting episode, but we can get started on your two M words.

Lamonica: Okay. So Shani will not be announcing a major transaction involving Morningstar today, but maybe a little bit later, who knows?

Jayamanne: You know.

Lamonica: Anything could happen. Alright, so let's start with some definitions. So at a high level, margin refers to how much a company keeps of what they sell. Now there's lots of different margins, but the basic concept is that a company sells a good or service for a certain price and then there are all sorts of expenses to create that good or service and then all sorts of expenses related to just running a company.

Jayamanne: And we hear a lot about the top line and the bottom line. The top line is the revenue or the sales that the company has that is a top line on an income statement. When you hear things like Apple experienced strong top line growth, that means that they just sold more stuff than they previously have. So sold more iPhones, Macs, air pods, just more. Then an income statement has lines that represent all those expenses that Mark talked about. And in the last line, while the bottom line represents the profits that accompany takes.

Lamonica: Your mother would be proud of that clear description of accounting terms. So while there's lots of different margins that allow us to look at different aspects of a company's performance, one of the most important figures is the net profit margin. That is dividing the profit by the revenue. So if a company had revenue of $100 and a profit of $50, that is a net profit margin of 50%.

Jayamanne: Which, incidentally, is really good.

Lamonica: Yeah. No, that is really good.

Jayamanne: And the second word that we are covering today is moat. A moat or economic moat refers to a company's ability to keep competitors at bay. Let's take a step back and explain this. Capitalism is competition. When working properly a capitalist economic system, means that companies are out there competing for customers, and in general that competition revolves around producing a better good or service by selling things cheaper than other companies, or by some combination of both. The quality good at a reasonable price.

Lamonica: Andthat's of course all very good for us as consumers. So competing over producing a better good or service benefits us because we get better things to buy. And competing on price means you get to buy them for cheaper. But if I take my consumer hat off and start to think about being a business, I soon understand that competing sucks. I constantly have to worry about competitors, what they are doing. And their products, how much they're selling for. I have to constantly invest in my products and services that I offer to make them better. And that of course costs money and I constantly have to try and make things cheaper, put them on sale or try and create that good or service for less.

Jayamanne: And we don't like competition as investors. We own the company, and that profit is ours. So, if the company has to invest in creating better products, so the company has to cut prices, that means less profit.

Lamonica: And some companies are able to fend off this competition. They have a competitive advantage over other companies. And what we're looking for is companies that have a sustainable competitive advantage, which of course is a moat.

Jayamanne: And the sustainability is important because often you could have a temporary competitive advantage by being the first to market. For instance, Myspace had a competitive advantage by being the first mover in social media. They launched on August 1, 2003. Facebook didn't launch until February 2004. And that competitive advantage lasted for a bit, but it wasn't sustainable, and Facebook took over and dominated the industry. And they did that because users felt they had a better product.

Lamonica: Did you have a Myspace account Shani?

Jayamanne: I did actually.

Lamonica: Did you?

Jayamanne: Yeah, but then I moved to Bebo.

Lamonica: What is Bebo?

Jayamanne: It didn't exist after very short amount of time. Basically what you did is you had a list of your friends and you had to rank them.

Lamonica: Wow.

Jayamanne: Yeah.

Lamonica: Talk about brutal competition.

Jayamanne: I know. So that was a huge thing in high school.

Lamonica: Really, did you ever get to number 1 on somebody else's list?

Jayamanne: A few, I mean it was sort of like, you know mutual. So if you were first on someone's account you kind of expect it to be first on their list.

Lamonica: Yeah, alright, so if we were -- if we had Bebo right now, where would I be?

Jayamanne: Do you want to know the answer to that?

Lamonica: Yeah, I do. Let's hear it.

Jayamanne: You wouldn't be anywhere on Will's because you're not friends with him.

Lamonica: Well, that's that's true. And where would I be on yours?

Jayamanne: Let's move on the episode.

Lamonica: Okay. Well, anyway, Shani was talking about, of course, examples of early mover advantage and how it can be fleeting. But there's lots of examples, right. So Yahoo search started in March of 1995, and Google didn't launch until three years later. And the point of all this is that a company needs both a competitive advantage and the ability to maintain that competitive advantage over the long term. So at Morningstar we have two different moat rankings. So we've got narrow moats, which we believe will last for 10 years, and wide moats which we believe will last for 20 years or more.

Jayamanne: We won't go through all the different moat sources because we covered that in our episodes, Swipe Right for Shares.

Lamonica: That's right, Shani. So the point of today is to tie our two M words together, moat and margin.

Jayamanne: And moat can feel like a really conceptual thing, and in a way it is. Determining if a company has a moat involves studying of the industry and the competitive dynamics around a company. It means understanding what consumers are looking for and the qualities of all the products of it. It means understanding if there are structural issues or legal statutes that protect a company.

Lamonica: But the result of a moat are far from conceptual. They show up in something tangible, and one of those tangible things is the margin. So as we said before, investing more and producing better goods or services means that a company makes less money since their costs go up. Selling goods for cheaper means a company makes less money, but the impacts of competition are, of course, bad for us as investors.

Jayamanne: Now, the reason that we're talking about margin is because it's a really important issue for investors right now, given inflation and some other economic factors. It's also really important because margins right now are historically high.

Lamonica: And we did talk about this also on our previous episode, but we'll summarize it again. We looked at the period between 2000 and 2011, while Shani was ranking people in Bebo. The margin on the S&P 500 was 6.2%. Over the last decade, it has grown to 13.4%.

Jayamanne: And a lot of the earnings growth that we've seen has actually been margin expansion. The environment we've been in since the early 80s has been lower taxes, less bargaining power for workers, increased globalization and increased efficiency through automation and other technological advances, mainly the computer, the Internet and data crunching. All of this has been amazing for companies.

Lamonica: And there are certainly all sorts of signs that this may be coming to an end, including COVID related rethinking of global supply chains, tensions between Western countries and China, and of course, what is happening in Russia. Plus we're seeing higher interest rates, shortage of workers and all sorts of things that may bring down margins.

Jayamanne: And a reversion to the mean could be really serious. If the S&P 500 went back from 13.2% to 6.2% and valuation levels didn't change, that would represent a 46% drop in the index. Now obviously that wouldn't happen overnight, and it would be a slow reduction in margin, but that could eliminate or at least really slow earnings growth going forward.

Lamonica: And that's why we want to talk about how moats protect margins and we'll go through a couple examples so you know what to look for. So everyone loves the banks, Shani, so let's look at them. So the big four in Australia all have wide moats from our analysts and that is because of their market share and the switching costs or the reluctance of consumers to switch banks. And their market share of course gives cost advantages related to their scale, meaning they can spread fixed costs to a wider customer base and get cheaper funding from both depositor's and on the wholesale market.

Jayamanne: And CBA has a net profit margin over the past five years of 40% and that's huge. If we look at Bank of Queensland, which is a much smaller bank and does not have a moat, their profit margin over the past five years is 25%.

Lamonica: And in business, you need to work really hard for customers. So being able to make 15% more off of every dollar they spend with you is awesome for shareholders. And in this environment that is a very good thing of course.

Jayamanne: All right. So let's look at deteriorating margin. If we go back and look at Zip over the past few years, we can see the issue with changing margins. In 2018, the net margin was minus 57% and it was negative because Zip was losing money. In 2019, it dropped to minus 13.4% and then in 2020 it dropped to minus 12.7%. Now we naturally see this with young companies. Initially they'll lose a good deal of money, but as their revenue increases, they'll eventually overcome the fixed costs associated with the new and expanding business.

Lamonica: Yeah, so up until 2020, everything looks pretty normal. That margin keeps dropping and gets closer and closer to zero. It will soon tick over, and Zip will become profitable. But that negative 12.7% was actually the high watermark. In 2021 the margin dropped down to negative 54%.

Jayamanne: And what happens if we look at revenue it grew at 153% which is really good. But then we start looking at expenses, the cost of that revenue went up 202%. Staff costs were up 272%. Marketing expenses went up 649%.

Lamonica: The most troubling sign is the cost of that revenue, because it is directly related to what they sold, which means it's costing them more to source funds that they lend out, or perhaps they're cutting the amount that they are charging for their goods and service. For instance, if they are faced with increasing competition, they could choose to charge a lower interest rate or lower fees so that people pick them over their competitors.

Jayamanne: Increased staffing and marketing could be considered an investment in the future, but the fact that marketing went up so much could also be a sign that they're struggling to compete. Because like product innovation and like cutting prices another way to compete and get new customers is to market. In that case, you're worrying if the amount they are spending on customer acquisition is more or less in the lifetime value of the customer they acquired.

Lamonica: Now in this case, our analyst doesn't think Zip has a moat. So those issues we could -- that we're seeing could be related to the relentless competition in a still developing industry.

Jayamanne: The takeaway is to continue to think about each company in a very basic sense, the same way you would think about a small business. Don't get caught up in the corporate spin you get in earnings releases, or the overly complicated way investing is portrayed. Over time, we're interested in companies that can grow their earnings. That happens in two ways you sell more stuff, or you keep a high percentage of what you sell.

Lamonica: And in an ideal world, you are doing both. So with large established companies that have had high margins over years or decades, you want to look at the trend. How are they changing? How is it changing over the years? And remember that certain years can be anomaly, so go and look at longer periods, like a five year average.

Jayamanne: And with younger firms, you're going to want to take a look at trends again, but you may have a less of a time period to look at and there may be more volatility. Try and figure out why there are big changes and be very worried if you're seeing less margin in the difference between sales and costs of goods sold. That is called gross margin. Even if a company is investing in growth activities like marketing or product development, the gross margin should get better over time because that's an indication that the company can at least scale a bit from increased sales.

Lamonica: Alright, so we did it Shani. We did two M words. We compared them. We learned about this Bebo thing. Or at least I learned about this Bebo thing, and now I'm worried about where I would rank and what I could do to move up in the rankings.

Jayamanne: Luckily, you don't have to worry about it.

Lamonica: Because it doesn't exist. But you have a mental Bebo board, don't you?

Jayamanne: I do, yeah.

Lamonica: Okay. Anyway, well, I think it's safe to say I am very close to the bottom or not on it but thank you guys for listening. All of the listeners of Investing Compass are at the top of Shani's Bebo board. Thank you very much. We love ratings or a comment in your podcast apps and please share this with your friends and family.