Economic Moat is the durable competitive advantage that a business has and which helps the company generate higher profits with longer duration of time. The term is very widely used by many investors, and often misunderstood by many.
Pat Dorsey is the founder of Dorsey Asset Management. He was Director of Equity Research for Morningstar from 2000 to 2011. In Pat Dorsey’s Talk at Google, he explains different types of Economic Moats with some examples, and below I have tried to summarise key takeaways from the video.
What are the simplest way to identify a moat?
Moats generally manifest themselves in pricing power. Any year if management mentions that due to macro reasons they are having soft realisations, means the company doesn’t have pricing power/moat!
Eg: Will anyone pay 20% premium for a Samsung/Sony phone? If not, its not a brand. If it comes with a new feature, it might get some premium for few months, but only until other mobile players replicate the feature. Whereas, Tiffany charges 20% premium for the same diamond. That’s a brand.
Return on Capital v/s Cost of Capital:
Companies generating Return on Capital above Cost of Capital for 15+ years!
Generally, high profits attract competition. Historically, high ROCE businesses have attracted capital, which has lead to drop in ROCE over 10-15 years. Also, there is minority of businesses where that’s not the case, and these are the businesses which truly have a moat.
Value of moats is largely dependent on their Reinvestment Opportunities.
Factors generally considered to be an Economic Moat, but aren’t in reality:
Any technology can be replicated by smart engineers, unless there is some lock-in period, switching costs or an industry standard is created.
Big is not a moat. Infact, small is often a better moat at times.
Eg – Aircraft business value chain: Boeing or Airbus don’t have any moats. They are too big, only 2 companies in market but still no moat! Who cares whether you are flying either Boeing or Airbus planes as long as they are safe enough! Companies manufacturing parts for the specific aircraft models earn premium, as Boeing & Airbus are just assemblers and they depend on these crucial parts. Their aftermarket business is the cream as only one guy can supply them!
Well Known Companies:
Just being well-known does not mean a Company has a brand/moat.
Types of Moats
Moat Type 1 – Intangible Assets
They increase customers’ willingness to pay or they lower search costs (time spent in finding alternative products). Brands might lose their moat if there are many changes in product. Aspirations of customers differ. So its very important that company should be able to adapt. Eg: Same Jack Daniels has different advertisement logo in Russia and China.
Its a legal monopoly, but there is risk of being challenged/expire. So a company with many patents is better than a company relying on a single patent.
Licences and Approval:
Not everyone can get it. Eg: Casino, Landfill, Aircraft parts (soul source generally with 40% margins), etc.
Moat Type 2 – Switching Costs
High costs of switching:
Costs of switching to an alternative product outweighs the benefits. Eg: Products that integrate with customers’ existing business Eg: Oracle. So upfront cost of implementation gets huge payback from renewals. So companies with this moat can raise price few % points every year.
Ongoing service relationships:
Eg: Elevator companies like Otis try to get high Attach Rate (attach a service contract while selling an elevator).
Importance of the product in entire scheme of things is very high. Eg1: Fastenal – Company’s customer has 1 bolt in assembly line, which if fails, it can stop entire manufacturing process for hours. The value of that bolt will be very high. Eg2: Lubrizol – Its lubricants can increase mining machine’s efficiency by x%. Customer would pay premium for its quality.
Cost as % of Total Cost (for the Customer):
The lower the ratio, higher premium the customer would pay to maintain the quality.
Moat Type 3 – Network Effect:
It increases in value as number of users increase.
Aggregators who connect fragmented demand with fragmented supply earn alot of economic rent from that. Eg: Supplier of dental equipments to different local doctors.
Interactive v/s Radial Network –
Network effect works well due to non-linearity of nodes v/s connection. If you have a web, and number of nodes in that web increases, then number of connections increase exponentially, and this makes it very hard to replicate once the network gains scale.
Radial network is lesser valuable than Interactive network. Eg: Western Union quote they have most number of branches in the world, but no one is sending money from Bangladesh to Mexico City, major money is being sent from Chicago to Mexico City. So a competitor can focus only on the channels which are essential and underprice in those channels to compete.
Moat Type 4 – Cost Advantages:
Process based advantage:
Its a cheaper way to do something. Eg: Southwest airlines, Dell, Zara (clothes cheaply made in Eastern Europe/North Africa rather than Bangladesh to reduce short travel time, as fashion changes every 6 months), etc. Problem is that it can be copied easily, eg: Southwest is no longer cheapest airline.
Scale based advantage:
Higher fixed cost distributed over larger base. It is hard to replicate. Scale based advantage in terms of distribution is very robust. Eg: UPS and FedEx has minimal cost of delivering additional package, but earn higher operating leverage. DHL (having dense network in Europe) lost $1 bn trying to compete with UPS in USA, as they couldn’t scale up. Some industries can only profitably support 1-2 players. 3rd player would make all lose money and hence 3rd player won’t enter. These businesses might not grow much, but are amazing cash cows.
Moat Type 5 – Good Management:
Good jockey will do very poorly on a goat when competing with a random person on a horse. So companies matter more than management!
- Managers matter in context of the moat: Required level of managerial skills is inversely related to the quality of business.
- Moats can buffer managerial mistakes. Eg: Microsoft minted money despite of Steve Ballmer.
- Good managers are constantly looking to widening the company’s moat (Eg: Amazon’s constant focus on customer experience. Trust matters more online than offline. How many of us now double check the price anywhere else before buying anything on Amazon? Clicking at new website will only take few seconds!)
- Bad managers invest capital outside a company’s moat, lowering overall ROIC. It is extremely important to differentiate this from being innovative and coming up with newer products. Companies doing it out of strength are generally innovative (Eg: Google is coming up with new products as a way of planting seeds for great businesses in future), v/s companies doing it just to preserve growth or because their core business is dying/growth slowing. So key differentiator is to understand whether it is coming out of strength or out of weakness.
- Company opening newer store/branches just to increase topline is not necessarily good. In many cases the newer stores have lesser ROIC! (Eg: There was a point Starbucks was opening way more stores than required at lower ROIC. Better way was to open lesser stores and increase sales per store by adding food items at existing stores).
- Exception to the Rule: There are tiny minority of managers who can create wealth via astute capital allocation, even if they don’t start with great horses. Eg: Warren Buffet at Berkshire started with a textile mill.
Moat Type 6 – Geographical Differences
- Local differences create moats (in a global context)
- Eg: Foreign companies are not allowed to own banks in Canada
- Minimum efficient scale
- Eg: South African retailers make ROCE way more than Costco. It is a small enough market to entertain only 2-3 retailers. Its hard for a domestic new player to compete and the market is too small for any global player to be excited about!
- Cultural preferences. Eg: Beer is a global product, but candies and snacks ain’t due to cultural differences!
Margin of safety v/s Opportunity Cost:
Most investors spend alot of time analysing margin of safety and not on analysing opportunity cost. One should make sure company will not go bankrupt, but if its a moaty business, one shouldn’t hesitate to pay some premium (however 100x P/E is foolishness).
Quantitative v/s Qualitative Data:
Quantitative data gets easily priced in the market, whereas Qualitative data (like moats) tends to be less efficiently priced. Bill Miller quote: “All of the information is in past, but all of the value is in future!”
2nd Order Thinking:
If companies with heavy moat is trading at very expensive valuations, consider companies supplying crucial ingredients to them! Eg: Flavouring agent company supplying to Coca-Cola, or enzymes company for yoghurt etc FMCG companies. FMCG company cannot play with the ingredient and hence ingredient manufacturing companies enjoy good margins.
It can be strategic advantage and it can be a form of economic moat for a company. They are very tough to find.
Very few companies having future operating leverage benefit are priced for it.
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