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Economic Moats, Durable Competitive Advantage and Wide Moat Investments

June 09, 2014 | About:

Definitions from www.investopedia.com:

  • Definition of Economic Moat

The competitive advantage that one company has over other companies in the same industry. This term was coined by renowned investor Warren Buffett (Trades, Portfolio).

  • Investopedia Explains Economic Moat

The wider the moat, the larger and more sustainable the competitive advantage. By having a well-known brand name, pricing power and a large portion of market demand, a company with a wide moat possesses characteristics that act as barriers against other companies wanting to enter into the industry.

  • Definition of Narrow Moat

A slight competitive advantage that one company enjoys over competing firms operating in the same or similar type of industry. A narrow moat is still an advantage for a company, but it is one that only provides a limited amount of economic benefit and will typically last for only a relatively short period of time before competition marginalizes its importance.

  • Investopedia explains Narrow Moat

The phrase "economic moat" was coined by legendary investor Warren Buffett (Trades, Portfolio). This phrase has since been refined to differentiate between "wide moats" and "narrow moats". Wide economic moats offer substantial economic benefits and are expected to endure for a prolonged period of time, while narrow moats offer more modest economic benefits and typically last for a shorter period of time.

  • Definition of Wide Economic Moat

A type of sustainable competitive advantage that a business possesses that makes it difficult for rivals to wear down its market share and profit. The term is derived from the water filled moats that surrounded medieval castles. The wider the moat, the more difficult it would be for an invader to reach the castle.

  • Investopedia explains Wide Economic Moat

Businesses that possess at least one factor of Porter's 5 forces model would possess a wide economic moat. For example, a business that holds an exclusive patent for the creation of a miracle drug would effectively keep potential competitors out of its business. Having few or no competitors would allow the company to continually generate high levels of profit. Legendary investor Warren Buffett (Trades, Portfolio) is renowned for his philosophy of investing in businesses with wide economic moat.

Lessons Learned from "The Little Book that Builds Wealth" by Pat Dorsey

  • Economic moats can protect companies from competition, helping them earn more money for a long time, and therefore making them more valuable to an investor.
  • Return on capital (ROC) is the best way to judge a company’s profitability.
  • Mistaken Moats: 1) Great products (i.e. Krispy Kreme, Netscape), 2) strong market share (i.e. Chrysler’s minivan, IBM’s PCs, General Motors), 3) great execution (i.e. Kodak), and 4) great management (i.e. JetBlue). They do not create long-term competitive advantages. They are nice to have, but they’re not enough.
  • The four sources of structural competitive advantage are 1) intangible assets (brands, patents, licenses, etc.), 2) customer switching costs (products or services that are hard to give up, like banks), 3) network economics (i.e. credit cards, Microsoft Windows and Office), and 4) cost advantages (stems from process, location, scale or access to a unique asset). If you found a company with one of these characteristics with solid ROC, you’ve probably found a company with an economic moat.
  • It’s easier to create a competitive advantage in some industries than it is in others. See page 118 for Moats by Sector.
  • Measuring Return on Capital:
    1. Return on Assets (ROA) measures how much income a company generates per dollar of assets.
    2. Return on Equity (ROE) measures the efficiency with which a company uses shareholders’ equity and is a great overall measure on returns on capital. (Note: A flaw in using ROE is a company can take on a lot of debt and boost ROE without becoming more profitable.)
    3. Return on Invested Capital (ROIC) combines the best in both worlds by measuring the return on all capital invested in the firm (both debt and equity).
  • Bet on the horse, not the jockey. Management matters, but far less than moats.
  • The Moat Process on page 145:

Has the firm historically generated solid ROC?

  1. No
    1. Is the firm’s future likely to be different from its past?
      1. No = No economic moat
      2. Yes
        1. High switching costs, network economics, low-cost production, and/or intangible assets
          1. No = no economic moat
          2. Yes = economic moat
            1. How strong is the company’s competitive advantage? Is it likely to last a long time or a relatively short time?
              1. Short = narrow moat
              2. Long = wide moat
  2. Yes
    1. Does the firm have one or more of the following competitive advantages: high switching costs, network economics, low-cost production, and/or intangible assets?
      1. No = no economic moat
      2. Yes
        1. How strong is the company’s competitive advantage? Is it likely to last a long time or a relatively short time?
          1. Short = narrow moat
          2. Long = wide moat
  • Valuation tools to consider:
    • Price to sales = most useful for companies temporarily unprofitable or posting lower profit margins.
    • Price to Book = most useful for financial services firms, because the book value of these companies more closely reflects tangible value of the business.
    • Price Earnings = beware of the earnings used, because forecasts aren’t always reliable. Estimate your own earnings
    • Price to Cash Flow = can help you spot that earns lots of cash relative to earnings.
    • Yield-based valuations = useful because you can compare the results directly with alternatives.
  • This is a great book to add to your library. Please check it out!

Lessons Learned About Durable Competitive Advantage from "The New Buffettology" by Mary Buffett and David Clark:

  • Buffett thinks that the best kind of business to own is one with high profit margins and high turnover.
  • He believes the second-best kind of business to own is one with either high profit margins or a high turnover to compensate for lower profit margins.
  • He is not interested in owning a business with both low profit margins and low turnover.
  • He has a selective contrarian investment philosophy where he will pass on price-competitive businesses regardless of how great the buying opportunities look.
  • Two-types of competitive advantage: 1) unique product or 2) unique service.
  • Not just competitive advantage but durable competitive advantage (a business must be able to keep its competitive advantage well into the future without having to expend great sums of capital to maintain it).
    • Low-cost durability like Hersey’s chocolate company.
  • Four types of businesses with durable competitive advantages:
  1. Businesses that fulfill a repetitive consumer need with products that wear out fast or are used up quickly, that have brand-name appeal, and that merchants have to carry or use to stay in business.
  2. Advertising businesses, which provide a service that manufacturers must continuously use to persuade the public to buy their products.
  3. Businesses that provide repetitive consumer services that people and businesses are consistently in need of (i.e. tax preparers, cleaning services, security services and pest control).
  4. Low-cost producers and sellers of common products that most people have to buy at some time in their life (i.e. jewelry, furniture, carpet and insurance).
  • Buffett’s checklist for potential investments: his 10 points of light
  1. Does the company show a consistently high return on shareholders’ equity (above 12%)?
  2. Does the company show a consistently high return on total capital (above 12%)?
  3. Do earnings show a strong upward trend?
  4. Is the company conservatively financed?
  5. Does the company have a brand-name product or service that gives it a competitive advantage in the marketplace?
  6. Does the company rely on an organized labor force (yes may be bad)?
  7. Can the company increase prices along with inflation?
  8. How does the company allocate retained earnings?
  9. Does the company repurchase shares?
  10. Are the company’s share price and book value on the rise?
  • Interested in learning more? Pick up this gem of a book. The whole Buffettology series comes highly recommended.

Lessons Learned from "Getting Started in Value Investing" by Charles Mizrahi

  • Quality companies are protected by economic moats, the all-important competitive advantage that makes it hard for competitors to gain market share. This economic moat is a concept worth remembering and applying in your analysis; even a good company without an economic moat won’t last long.
  • Four basic types of economic moats:
    1. Brand (Coca-Cola sells better and is more profitable than a generic brand of soda).
    2. Switching (customer loyalty or the inability and unwillingness to go elsewhere).
    3. Cost (dominating a commodity type industry through lower prices for the same or better value).
    4. Protection (ownership of a product or service that no one else is able to offer).
  • ROE and net profit margin are two of the first ratios to look at to determine possible economic moats. Compare them to industry averages and if trending higher they are worth looking at. If not, it’s a waste of time so look elsewhere.

Wide Moat Investments

  • Wide Moat Investment is a phrase coined by Vic Grossi, which compares what type of asset an investor should use in order to maximize potential profits when investing in the same company. For example, should you buy a company’s stock or its bond? If a company is in a turnaround phase, would convertible bonds be safer than common stock?
  • You can own a company or its tradable assets or other investments.
  • Stocks, bonds, options, warrants, syndicated/bank loans, notes, futures, preferred stock, credit default swaps, tax liens, trade or rent agreements/contracts, pension assets/obligations, union obligations and other derivatives are weighed differently in terms of potential risks and rewards. One may be a wider moat investment in the same company.
  • A company is a modern social construct created to distract the layperson from conducting proper research on actual investments, the separate agreements a "business/company" creates with other entities. Some agreements/contracts may be backed by obligations e.g. assets (bonds, loans, rental agreements, employment contracts, union obligations, etc.) and others are not e.g. $0.01 par common stock. How many people read a bond contract? If you are looking to buy common stock of a "company," you better read the bond, loan, rental, etc. Prospectus and supplement.
  • The devil is in the individual contract details.

About the author:

Nelson Nguyen
Experienced professional with expertise in financial statement analysis, value investing, and financial modeling. Past employment with the government (Internal Revenue Service), banking, insurance, and accounting service sectors. Licensed CPA with individual and corporate tax compliance experience and a 2014 Level II Candidate in the CFA Program.

Visit Nelson Nguyen's Website


Rating: 5.0/5 (10 votes)

Voters:

Comments

irie267
Irie267 - 1 month ago

Interesting. Aswath Damodaran warns against using the book value of financial service firms, due to mark-to-market accounting: "...While the return on equity for a non-financial service firm can be considered a measure of return earned on equity invested originally in assets, the same cannot be said about return on equity at financial service firms, where the book equity measures not what was originally invested in assets but an updated market value."

http://people.stern.nyu.edu/adamodar/pdfiles/papers/finfirm09.pdf

Just something to think about.

nnnguyen1221
Nnnguyen1221 - 5 days ago

If you are interested in learning how to build an Economic Moats Model, please checkout the following article I wrote: http://www.trueinvestmentresearch.com/2014/07/19/build-economic-moats-model/

batbeer2
Batbeer2 premium member - 5 days ago

Thanks for an article worth reading.

You say:

ROE and net profit margin are two of the first ratios to look at to determine possible economic moats. Compare them to industry averages and if trending higher they are worth looking at. If not, it’s a waste of time so look elsewhere.

IMHO that is one of the worst mistakes you could make. A moat creates the ability to raise prices without losing market share. High ROE comes form already having raised prices. At some point, there's a balance. It becomes worthwile for the competition to come at you regardless of your moat.

What you want to look for is a company that has an obvious moat but has not (yet) raised prices.

You cannot hope to compete against Ryanair, AON or USG but for all sorts of reasons they don't report nice and stable ROEs like KO or JNJ. Nevertheless they have moats; precisely those that you've desrcibed in general terms. Understanding why they are not currently reporting great ROEs may give you the opportunity to buy a moat for free.

In short, a sustained high ROE probably means the company has a moat but the reverse is not true. You are not wasting your time thinking about the moats of USG, AON or Ryanair. Hardly anyone does.

Just some thoughts.

Please leave your comment:


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