Lesson #10: Understanding Moats

Value Investing Masterclass - Safal NiveshakIn the previous lesson we touched upon the concept of moat while talking about characteristics of great businesses.

Moat is such an important idea that it needs to be understood and appreciated by every value investor. We are going to dive deeper into concept of economic moat and learn how to figure out if a business has it.

“We like stocks that generate high returns on invested capital,” Warren Buffett told those in attendance at Berkshire’s 1995 annual meeting, “where there is a strong likelihood that it will continue to do so.”

“I look at long-term competitive advantage,” he later added, “and [whether] that’s something that’s enduring.”

According to Buffett, the economic world is divided into a small group of franchises and a much larger group of commodity businesses, most of which are not worth purchasing.

He defines a franchise as a company whose product or service (1) is needed or desired, (2) has no close substitute, and (3) is not regulated.

Individually and collectively, these create what Buffett calls a ‘moat’ – something that gives the company a clear advantage over others and protects it against incursions from the competition.

The bigger the moat, the more sustainable, the better it is.

Buffett says…

The key to investing is determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.

He suggests that buying a business is akin to buying a castle surrounded by a moat. Buffett wants the economic moat around the businesses he buys to be deep and wide to fend off all competition. He goes one step further, noting that economic moats are almost never stable; they’re either getting a little bit wider, or a little bit narrower, every day.

So he sums up his objective as buying a business where the economic moat is formidable and widening.

As he wrote in his 1994 letter to shareholders…

Look for the durability of the franchise. The most important thing to me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.

Now, as much important as they are, moats are fairly rare and come from a variety of things, such as brand, intellectual property, scale economies, a regulatory advantage, high customer switching costs, or some sort of network effect.

My goal in this lesson will be to help you develop a systematic way to explain the factors behind a company’s moat. We would also understand how you can assess whether a moat is declining or widening.

To really study the subject of “moats”, it’s important that we ingrain this in our minds that we are trying to also study the “sustainability” of moats. Only then can we work towards identifying businesses that can really create wealth for us in the long run.

In his brilliant book, The Little Book that Builds Wealth, here is how Pat Dorsey shows the difference between a company with moat and one without…

moats_image2

In the above image, time is on the horizontal axis, and returns on capital are on the vertical axis. You can see that returns on capital for the company on the left side – the one with the economic moat – take a long time to slowly slide downward, because the firm is able to keep competitors at bay for a longer time.

The no-moat company on the right is subject to much more intense competition, so its returns on capital decline much faster.

The dark area is the aggregate economic value generated by each company, and you can see how much larger it is for the company that has a moat.

Sources of Economic Moat

For most companies having long term sustainable moats, one or more of the following characteristics exist –

  • Strong brand power
  • High switching costs
  • Network effect
  • Low cost of operations

Strong brand power

The very fact that strong trademarks or brands take a long time to build make them such a strong source of economic moat for a company that have them.

Take a look at some of the biggest wealth creators in India over the past few years – Asian Paints (average annual return of 36% during 2001-13), ITC (27%) and HDFC (22%). While the inherent quality of these companies’ businesses has helped them considerably in creating value for shareholders all these years, one big reason they have been able to do well is the brand power they command in their respective markets.

Brands, like patents, trademarks, and licenses, are “intangible assets” whose real value you won’t find in a Balance Sheet. And thus they are difficult to assess for most investors.

But remember, a brand creates an economic moat ONLY if it increases the consumer’s willingness to pay or increases customer captivity. So the popularity of the brand matters much less than whether it actually affects consumers’ behavior.

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.

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 in your computer? Maybe never. Or your DTH set top box or Internet service provider? Maybe once in the last few years. Or your newspaper? Maybe once or twice in the last few years.

Now, do you remember when you last changed your fuel pump? Or the retail store from where you buy clothes? Maybe every time you go to a different fuel pump or a different retail store – depending on where you are and what discounts are on offer.

Now, switching costs can be tough to identify because you often need to have a thorough understanding of a customer’s experience – which can be hard if you’re not the customer.

But this type of economic moat can be very powerful and long-lasting, so it’s worth taking the time to seek it out.

Network Effect

Charlie Munger calls “network effect” the demand-side economies of scale, as it results when a product or service becomes more valuable as more people use it.

Consider the example of companies like eBay, Twitter, Facebook, and Google, which have gotten more valuable as more people have used them.

Or for that matter a newspaper business like DB Corp. The more people read its newspapers, the more advertisers and classifieds it can attract. And more the number of classifieds, the more the people (searching for jobs, spouses etc.) who would read its newspapers.

So the dominant network not only gets the most users and the benefit of scale, but also the switching costs for its customers rise as the network becomes larger.

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, but when you find one that is selling at an attractive price, you must lap onto it.

Low Cost of Operations

One way a company can keep earning excess returns and thus keep creating shareholder value is by charging higher price for its products/services year after year without seeing any impact on its volumes (pricing power).

It can do this only if it enjoys any of the moats we’ve discussed so far – brand power, high switching costs, and network effect.

Now, there’s another side of the return equation that can create moat for a business – its cost of operations.

A business can dig moats around its business by having sustainable lower costs than the competition.

Now it’s important to understand lower cost of operations in itself isn’t not an advantage. Real cost advantages have to be structural, and thus sustainable. Structural advantage for a business is created when it has ‘something’ that its competitors don’t have.

For example India’s leading steel companies, Tata Steel and SAIL, have access to captive (own) iron ore mines, which helps them to reduce the cost of procuring iron ore (raw material for manufacturing steel) from the open market.

For most businesses, a competitive advantage is not sustainable over an extended period of time.

Overall, at a very practical level the discussion in this lesson illustrates that there are some rules of thumb one can use to test the strength of a moat.

At the top of the list is whether the business has pricing power. For example, if you must hold a prayer meeting before you try to raise prices, then you don’t have much of a moat, if any, argues Buffett.

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