In a previous post, I highlighted that just by looking around you, perhaps at the products and services you buy or at all the companies in the industry you work in, you can identify (almost better than anyone else) a fantastic list of potential investments that you really understand. But identifying growth potential isn’t enough. In this post, I want to discuss the next steps we can take to really zoom in on great investments.
Why isn’t growth potential enough? In a capitalist system, areas of growth and high potential returns attract capital in the form of new competitors, so pretty quickly, you get to a situation where the sizeable profits you thought the company would enjoy from its growth are bid away as competition heats up. This is why the next step in finding great investments is to look at how a company can protect its market position from others.
What is an Economic Moat?
In the medieval period, most castles and forts were surrounded by a deep channel or ‘moat’ filled with water to protect against invaders. The wider the moat, the more difficult it was to storm the castle. In the modern day, Buffett has used the analogy to explain how he identifies the most formidable companies, who are more certain to hold on to their profits and grow them, giving their investors years of compounded growth potential.
The moat he refers to is basically the sustainable, competitive advantages that protects a company and allows it to earn high profits and shield its market share, thus staying ahead of the rivals over a prolonged period.
Why Does it Matter?
But why should we as investors care if the business has built this economic moat? Because companies with wide economic moats are not only more likely to survive over long periods but are also more likely also to generate consistently high profits. “The companies with a sustainable advantage offer better revenue visibility and certainty of future cash flow. In the absence of such a benefit, it would be difficult to predict future performance,” explains Ajay Parmar, head of institutional research, Emkay Global Financial Services.
However, not many companies enjoy these sustainable advantages, it’s actually quite rare. One of the principles of modern economics is that, given time, competition will erode any and all advantages enjoyed by a firm. For example, even if a company leverages its first-mover advantage to rake in profits, a host of new players will very soon try to duplicate operations or discover better operating methods, taking away this temporary advantage.
“We like stocks that generate high returns on invested capital, where there is a strong likelihood that they will continue to do so. I look at long-term competitive advantage and [whether] that’s something that’s enduring.” Warren Buffet
The economic moat principles have become a useful way of assessing just how a great a company is at staying ahead and continuing to grow. Looking at the business through the lens of its moat characteristics helps us answer this key question:
Why do some companies stand out for decades while others wilt away after a few prosperous years?
According to Economic Moat theory, the presence and size of an economic moat correlates to a company’s ability to sustain long-term profitability. Measuring the actual size of the moat is difficult and often can’t be done mathematically. It’s more a framework to think through the durability of competitive advantage.
Moats are changing
The world may be changing fast but the idea of a moat is still relevant. In the 20th century, the biggest companies in the world were built on moats of economies of scale or government. Standard Oil, for example, built its monopoly by buying up smaller competitor refineries and building a global distribution network. Eventually, the company controlled about 90% of all the refineries and pipelines in the United States and could set its own prices. Today, however, the most durable moats are being built on different types of advantages, such as network effects, data, and repeat engagement within a product ecosystem. Google, for example, started its moat by developing a better algorithm for indexing and searching the internet. The company has since strengthened that moat by putting that advantage to work in transportation, shopping, and most importantly, advertising.
For most companies with long term sustainable moats, one or more of the following characteristics exist:
Strong brand power
The very fact that strong trademarks or brands take a long time to build make them a strong source of economic moat for the company. Brands, like patents, trademarks, and licenses, are “intangible assets” whose real value you won’t find in a balance sheet. As such, they are difficult to assess for most investors. The investors best placed to judge the brand are the brand’s consumers and people who work in that sector.
Not to get too technical though: remember, a brand creates an economic moat ONLY if it increases the consumer’s willingness to pay or increases customer captivity, not just because it’s popular. If consumers will pay more for a product – or purchase it with regularity – solely because of the brand, you have strong evidence of a moat.
The fact that these brands are often not valued as an asset in company accounts helps to explain why some valuation metrics can look out of the norm as investors assign high value to something that the accounting principles in company accounts basically ignore.
High switching costs
Switching costs are those one-time inconveniences or expenses a customer incurs in order to switch over from one product to another, and they can make for a very powerful moat.
Do you remember the time you last changed your bank? Maybe never. Or the operating system that resides on your computer? Maybe not for years. Or your TV set top box or Internet service provider? Maybe once in the last few years. Now, do you remember when you last changed the retail store where you buy clothes? Maybe you regularly consider buying from a different retailer – whether it’s in an actual store or online. Now, switching costs can be tough to identify because you often need to have a thorough understanding of the customer experience – again where using your everyday experience as a consumer is invaluable.
Some companies become more valuable as more people use them: consider companies like eBay, Twitter, Facebook and Google as examples. So the dominant network not only gets the most users and the benefits of scale, but also the switching costs for its customers rise as the network becomes larger.
For example, the telephone wasn’t very useful when only a handful of first adopters had one. The more people that acquired telephones, however, the more useful it got. Once virtually everyone had a telephone in their home, it became indispensable. The same logic has powered the growth of social networks, which are extremely sticky if all of your friends are on them — and useless if they’re not. While Amazon’s dominance has been built on a variety of moats, its central business advantage comes from harnessing the marketplace network effects that come from aggregating suppliers and customers.
Overall, the network effect is a pretty powerful competitive advantage. It is not insurmountable, but it’s a tough one for a competitor to crack in most circumstances. This is one moat that is not easy to find as it’s difficult to build and existing ones are often highly valued as a result.
Low cost of operations
A business can dig moats around its business by having sustainably lower costs than the competition. Now it’s important to understand lower cost of operations in themselves are not much of an advantage, they have to be structural to be sustainable. Structural advantage for a business is created when it has ‘something’ that its competitors don’t have. For most businesses, a competitive cost advantage is not sustainable over an extended period of time.
This Kind of Analysis isn’t actually New
Like the trends you see in new forms of exercise, new business analysis terminology is often merely a repackaged set of already understood principles. Back in the day, people studying businesses would use Micheal Porter’s five forces to assess competitive advantage. This isn’t dissimilar really from looking for economic moats: I believe Porter’s framework is still very helpful when you are trying to understand how sustainable a business’ competitive advantage is.
As you can see, it’s all pretty much common sense if you think about it. It’s a competitive game and some companies are better placed to win than others. We want to choose the investments with the best odds, so this is where this kind of competitive advantage analysis fits in.
The Arguments Against Economic Moats
So, like every investment approach, not everyone agrees it’s useful. Enter, Elon Musk:
“I think moats are lame…If your only defence against invading armies is a moat, you will not last long. What matters is the pace of innovation–that is the fundamental determinant of competitiveness.” Elon Musk
We have seen how a moat is deemed to exist if a business has a sustainable competitive advantage, essentially that it has the power to keep what it has built. Musk’s counterargument, however, draws parallels to Clayton Christensen’s celebrated theories on disruptive innovation, the overriding narrative of the “David vs. Goliath” story, which has been much in evidence in the past decade. This school of thought holds that it is possible to use technology to tackle a large behemoth and turn an industry on its head. Musk himself has, of course, played a part in changing the course of the payments and automobile industries.
Do Economic Moats Still Matter?
You may win whether you are attacking a castle or defending it. One company may come along and completely change the world so in that sense, moats can seem “lame”. But overall, businesses with inherent moat advantages are far more likely to win and therefore represent lower risk long term all weather investments. One thing is for certain, once you own the castle, you are more likely to remain there and see off most attacks, which is why economic moats still matter.
Morningstar is a preeminent leader in the moat think space and they have even created an index comprised of a basket of moat stocks. As expected, an ETF that replicates this group of premier companies has significantly outperformed the S&P 500 over a sustained period.
I feel on balance looking at economic moat characteristics is a very useful mindset when looking for great companies. We are trying to avoid negative surprises and want to benefit from the magic of years of growth compounding and this is what big strong castles offer us.
Disclaimer: this information does not constitute any form of advice or recommendation by Crowdsense Ltd. and is not intended to be relied upon by users in making (or refraining from making) any investment decisions. Appropriate independent advice should be obtained before making any such decision.