“A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital” Warren Buffett
My most successful and long-lasting investments have always come about when I’ve invested in a company with a strong and enduring “moat”. Buffett worked out long ago that a company that’s able to sustain high returns over a multi-year period will generate outsized rewards for shareholders.
Many investors and analysts confuse a high ROIC with an economic moat. While a high ROIC can be an indicator of an economic moat, it’s dangerous to equate the two because more often than not the high ROIC is a result of temporary factors. The nature of capitalism is such that high returns are rarely sustainable. Other companies will notice those returns and capital will immediately be attracted to that industry. If a business can earn a ROIC of 20%, why wouldn’t I invest capital in that area? This brings in competition, prices are lowered, and over time ROIC will decline.
An economic moat is a wonderful thing because it allows a company to keep earning a high ROIC, unencumbered by competitive attacks. A high ROIC and strong growth are powerful bedfellows, allowing companies to grow earnings without investing excessive amounts of capital. While these situations are hugely valuable, they are also incredibly rare. In practice, what may look like a wide moat can easily be breached when subjected to a sustained attack from competitors. This is why it pays to be aware of the different types of moat and how they protect returns.
A Strong Brand
Buffett is attracted to businesses with strong brands, like Coke or Gillette. These businesses are able to charge more for their product than competitors because of the inherent value customers put on the brand. Great brands create a strong bond with customers, who trust the product will be high quality and associate it with something that goes beyond the value of the product itself. StockViews analyst Liam Garrity-Rokous recently wrote about Harley Davidson in a StockViews article, which I think does a great job of summing up the strength of the brand:
“I’m not quite sure how to label people who tattoo their bodies with a company’s logo, but the simple word “consumer” does not suffice. More than 700,000 motorcyclists belong to Harley riding groups in the U.S. and Canada, and a good many likely have a Harley-Davidson tattoo. These 700,000+ motorcyclists act as ‘brand ambassadors’ who tout the benefits of riding a Harley to anyone who will listen. This community drives the Harley-Davidson brand by promoting a lifestyle, not just a machine”
In his book “The Little Book that Builds Wealth”, Pat Dorsey argues the test of a brand’s value is whether a consumer is willing to pay a premium versus a similar product without a brand:
“A brand creates an economic moat only if it increases the consumer’s willingness to pay or increases customer captivity… The next time you are looking at a company with a well-known consumer brand—or one that argues that its brand is valuable within a certain market niche—ask whether the company is able to charge a premium relative to similar competing products. If not, the brand may not be worth very much”
Patents provide strong legal protection for a company’s intellectual property. Depending on the type of patent, these can be very difficult to circumvent. Pharmaceutical companies are often able to charge multiples of the cost of a drug for periods of up to 20 years. Of course this needs to be weighed against the amounts invested in R&D and the risks of replenishing the pipeline as patents expire.
If there is a cost involved for a customer to switch from one supplier to another, it can allow the incumbent to charge a significant premium for its product. The switching cost can either be monetary or involve an additional effort that most customers are not prepared to endure. My favorite example in this category is reconstructive implants for hips and knees. Surgeons that were trained to use Smith and Nephew products are unwilling to change to another brand because this is what they used in training and its what they work with every day. They’re unlikely to accept a change to another brand just to save a few dollars. Equally designers who have been trained on Photoshop or Illustrator would be reluctant to try out a new competitor unless it offered meaningful benefits over the Adobe version.
A network is very difficult to build up, but once you have it its almost impossible for a competitor to assault it. Networks naturally shift towards the dominant player since this is where the greatest number of transactions occur. The value to the user is a function of the number of other members already on the platform. Ebay is the ultimate online auction platform matching buyers and sellers. With around 85% of internet auction traffic, the chances of a smaller competitor having success with a competing site are close to zero.
There is some debate as to whether a “Process” is a truly sustainable competitive advantage. In theory it’s easy enough to copy another company’s process. However in practice, it can take a surprising amount of time for incumbents to react to an innovative new business model. Warren Buffett’s Geico employed a direct-to-consumer sales model, which was much lower cost than employing agents.. Ford’s Model T enjoyed a lower cost than other auto manufacturers for many years because of the unique production techniques that were employed. Inditex of Spain has a “fast follower” process where it can copy runway trends in a very short space of time, thanks to a combination of in-house designers, “near-sourcing”, and small production batches. Can this be copied? Of course, but it would require retailers to completely overhaul the way they currently operate. This is not a decision the incumbents will enter into lightly.
It is possible for certain companies to have a local monopoly due to its location. Aggregate companies are the best examples of this I have encountered. Because it can be very expensive to transport aggregates over long distances a single quarry has a local monopoly over its surrounding area. The lack of competition leads to high returns and stability of those returns over time.
Economies of Scale
As Pat Dorsey says in his book, what’s important is not absolute size, but size relative to the next biggest player. There are some industries that naturally provide an advantage with scale. Large distribution networks is one obvious economy of scale. Coca-Cola has a huge distribution network – with unparalleled depth and breadth. It costs very little for Coca-Cola to push another marginal unit through its existing network. The scale also allows Coke to spend more on advertising than other companies. Walmart’s size gives it huge buying power that is hard for smaller competitors to match. Walmart is a good example of a company that started with a process advantage and used that advantage to grow to a size where it could exercise economies of scale.
We encourage all analysts on the StockViews platform to look for companies which are likely to enjoy a sustainable competitive advantage. Once you think you’ve found a company with a moat, you need to really give some thought as to whether the advantage is sustainable. If a genuine moat exists, you are likely to have found a company with the potential to generate some great returns for you. However, if you invest in a company where the moat can be breached, not only will the earnings drop significantly but the multiple applied to those earnings will fall sharply too. Study the moat carefully before deciding!