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Grahamites
Grahamites
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Notes From Peking University's Fall 2020 Value Investing Course - Lecture 4, Part 2

How to better understand an economic moat

November 01, 2020

After introducing the definition of economic moat, Chang Jing expanded the discussion to include other aspects of economic moat, such as its relationship to margin of safety and different sources of economic moat. Below are my notes from this part of the lecture.

Relationship between economic moat and margin of safety:

Economic moat can be thought of as the extension to the idea of margin of safety. If we go back to Bruce Greenwald's three-element approach, we'll see that in a perfect competitive market, the market price of a business should equal to the value of the assets. But if the company possesses economic moat, the market price of the business will include a premium to the value of the assets.

Both franchise value and competitive advantages are components of economic moat. Franchise value competitive advantages will enable the business to earn above-average profits and grow faster than the industry. Both earnings power and growth value can be the source of our margin of safety. If the price we pay only reflects the value of the assets, and if we are confident in the business' earnings power and growth power, the margin of safety could be well built in.

Sources of economic moat:

Chang lists the following potential sources of economic moat, including:

  • Sustainable cost advantage.
  • Structural barrier to enter.
  • Natural resources advantage.
  • Technology advantages.
  • Brand power.
  • Switching cost.
  • Network effect.
  • Patent and franchise.
  • Scale advantage.
  • Platform advantage.
  • Ecosystem advantage.

As value investors, we should qualify each of the sources of economic moat. But what does it mean by qualifying the source? My understanding is that by qualifying the source of economic moat, we are essentially trying to assess whether what the company claims as its economic moat is actually its true economic moat. For instance, many companies claim that technology is their competitive advantage, but if the technology can be easily disrupted, then it's not sustainable. Therefore, the technology advantage is not a source of economic moat in this case.

Similarly, operating efficiency is not a source of economic moat, per se. For instance, a restaurant may have a very lean and efficient operation, but if the flavor of its dishes doesn't appeal to customers, it won't survive long. Or if a new restaurant opens up nearby and has a unique theme, even if it has less efficient operations, it can put the more efficient restaurant out of business.

The above two cases are what Chang calls traps of economic moat. It happens all the time in the investment world.

Frameworks for studying economic moat:

Chang shared his own list of frameworks for studying economic moat.

Porter's five forces

This is one of the best and mostly widely used frameworks to understand economic moat. It has many advantages. Everyone should be familiar with this framework, but we should also be aware of the limitations of Porter's framework. For instance, a win-win relationship is not considered because a big assumption behind Porter's five forces theory is that everyone will fight for their own best interest. Another limitation of this framework is that there might be other forces at work, such as exit barrier. For instance, in a capital-extensive industry, the barrier to entry might be very high due to large initial capital outlay, but this means the barrier to exit is also very high because if you invest billions of dollars on a manufacturing line, often it's better to keep the line running than to completely shut it down.

Jim Collins' framework

There are three frameworks we can learn from Jim Collins – the good to great framework, the Level 5 Executives framework and The Hedgehog and the Fox framework. Chang said that Collins' framework for leadership is very helpful, especially the Level 5 Executive framework, which is an important framework for assessing management teams.

Competitive theories in modern economics

This framework includes the supply-demand curve and cost curve. This is a good framework to think about economy of scale, especially for businesses with intense price competition. In my experience, this framework explains the business model of many manufacturing companies which produce commodity products with very little product differentiation.

Theoretical works on brand, supply chain and ecosystem

There are many other theories on brand, supply chain and ecosystem, each focusing on a niche topic. For instance, there are good theories on how to build a brand and how to operate an efficient supply chain. We should study these theories as well.

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About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

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