Chokepoint

A chokepoint in the business world refers to a critical point of control within an industry's value chain or ecosystem. Imagine a narrow mountain pass—any army wishing to cross the mountains must go through it. The force that controls the pass holds immense strategic power. Similarly, a company that controls an economic chokepoint has a powerful competitive advantage, often a deep and wide moat. This control gives the company extraordinary pricing power, allowing it to effectively act as a tollbooth, extracting high profit margins from customers and suppliers who have no viable alternative. For investors, identifying companies that own these strategic positions is a key to finding truly exceptional, long-term investments. These businesses are often shielded from the brutal forces of competition, enabling them to generate predictable and durable cash flows for years, a hallmark of the businesses championed by value investing practitioners like Warren Buffett.

Value investors are on a perpetual treasure hunt for businesses with durable competitive advantages. A chokepoint is one of the most powerful and enduring advantages a company can possess. Unlike a temporary edge from a hot product or a clever marketing campaign, a chokepoint is a structural feature of the market. This structural dominance provides several benefits that are music to an investor's ears:

• Durability: Chokepoints are, by their nature, difficult to challenge or replicate. This means the company's high returns are likely to persist for a very long time.
• Predictability: The essential nature of the product or service, combined with limited competition, leads to stable and predictable revenue and cash flow streams. This makes the business easier to value with a higher degree of confidence.
• High Returns on Capital: Chokepoint businesses often don't need to reinvest massive amounts of capital to maintain their dominant position. They can generate substantial profits and return that cash to shareholders through dividends or share buybacks.

Chokepoints can manifest in several forms. Recognizing the different types can help you spot them in the wild.

These arise when a company's technology becomes the industry standard or is a critical, non-negotiable component for other businesses.

• Example 1: Operating Systems. For decades, Microsoft's Windows was the undisputed chokepoint for personal computing. Nearly every PC manufacturer had to license it, giving Microsoft a license to print money.
• Example 2: Specialized Equipment. The Dutch company ASML is the only manufacturer in the world of the extreme ultraviolet (EUV) lithography machines required to make the most advanced semiconductor chips. If you're TSMC or Samsung, you have to buy from ASML.
• Example 3: Software Ecosystems. Adobe Inc.'s creative suite (Photoshop, Illustrator) has become so embedded in the workflows of creative professionals that its dominance is protected by high switching costs and powerful network effects.

These are the most literal chokepoints, controlling the physical flow of goods and services.

• Example 1: Railroads. A railroad company like Union Pacific might own the only track passing through a key geographical region, giving it a monopoly on freight transport along that route.
• Example 2: Airports and Ports. The operator of a major international airport or a deep-water port controls a vital gateway for trade and travel, allowing it to charge landing fees and rent to all who wish to use it.

These chokepoints are created not by market forces alone, but by government grants of power or legal protections.

• Example 1: Patents. Pharmaceutical companies that develop a new life-saving drug are granted patents, giving them an exclusive right to sell that drug for a set period. This legal monopoly is a very powerful, though temporary, chokepoint.
• Example 2: Rating Agencies. Companies like Moody's and S&P Global hold a duopolistic chokepoint in the credit rating industry. Many financial regulations require bonds and other debt instruments to be rated by these specific agencies, creating a government-endorsed chokepoint that is nearly impossible for new competitors to break into.

Finding a true chokepoint business requires critical thinking. Here are some questions to guide your analysis:

• Is it Essential? Is the company's product or service absolutely critical for its customers to conduct their own business?
• Are there Alternatives? How many realistic substitutes exist? Is the company a monopoly or part of a cozy oligopoly? If customers wanted to leave, could they?
• What are the Switching Costs? How difficult, expensive, or painful would it be for a customer to switch to a competitor? The higher the pain, the stronger the chokepoint.
• Who has the Power? Does the company dictate prices, or do its customers? A company that can consistently raise prices year after year without losing business likely controls a chokepoint.
• What is the Source of Power? What specific factor—technology, intellectual property, regulation, geography—creates and protects this chokepoint? How durable is that factor?

While incredibly attractive, chokepoint investments are not without risk.

• Regulatory Scrutiny: Dominance breeds resentment. Powerful chokepoints often attract the attention of regulators concerned about antitrust violations. A government lawsuit can cripple even the mightiest company.
• Technological Disruption: A chokepoint is only powerful as long as there is no way around it. A new technology can create a bypass, rendering the old chokepoint obsolete. Blockbuster Video had a chokepoint on movie rentals until Netflix (streaming) built a whole new highway.
• Valuation Risk: The market is not stupid. It often recognizes the quality of these businesses and prices them at a premium. The greatest risk for an investor is often not the business failing, but simply paying too high a price for its excellent prospects. A wonderful company bought at a terrible price will likely lead to a terrible investment return.