During the Daily Journal meeting held earlier this year, a shareholder from Houston asked Charlie Munger (Trades, Portfolio) what in his opinion was the most underappreciated moat. Mr. Munger did not answer the question, but I thought this was a question worth spending some time on.
It would be presumptuous for me to give a definitive answer to the question. So instead, I would like to talk about a moat that is less talked about by investors – a well-established distribution system.
First of all, for some businesses such as Coca Cola (KO, Financial), Walmart (WMT, Financial) and Amazon (AMZN, Financial), this moat is widely understood by investors. I won’t waste readers' time on those businesses.
In some cases though, especially in the small cap and micro cap world, the power of distribution network is often either misunderstood or underappreciated. A good distribution system can give a business enormous power in terms of reaching a larger consumer population, whereas the lack of an extended distribution system can put some serious constrains on a business’s ability to grow. This means having a great relationship with the distributors is extremely important because they know the customers and can direct sales to the customers at their will.
Let me use IDEXX Lab (IDXX, Financial) as an example to illustrate this point. A big part of IDEXX’s business is the point-of-care veterinary diagnostic products. The vets use IDEXX’s product to perform diagnosis on your pets’ health information.
IDEXX used to have a significant competitive advantage over its competitors because of its exclusive distribution relationships with Henry Schein and MWI. Both Henry Schein (HSIC) and MWI are among the largest distributors of veterinary diagnostic products. When a vet needs to shop for a testing equipment such as an analyzer, he or she is likely to go to Henry Schein and MWI for references. Since IDEXX had exclusive contracts with both of them, IDEXX’s products are the only one that can be seen on the shelves by the vets. When we tie this into the availability bias from Charlie Munger (Trades, Portfolio)’s human psychological framework, we can see that IDEXX unique distribution relationship with Henry Schein and MWI gives IDEXX an enormous advantage over its competitors such as Abaxis (ABAX, Financial), who has to basically go door-by-door to market its products. Not only does it cost more for IDEXX’s competitors to promote their products, but also it’s less efficient. This makes IDEXX’s competitors' lives pretty damn hard.
Then all of a sudden, IDEXX disclosed in its latest 10K that it has ended its relationship with the distributors and went to an all-direct sale system. This is truly astounding and befuddling. By doing this, IDEXX is giving up a really important competitive advantage it has built over time. It removes a significant barrier for its competitors in terms of getting their names out there in the market in a much easier way. Now if you go to MWI’s website, you can see IDEXX’s competitors’ names listed as manufacturer partners and IDEXX’s name is not there anymore.
I suppose this is the result of disagreement or unpleasantries between IDEXX and its largest two distributors. But whatever the reason is, I think the moat of IDEXX has narrowed significant and it would not surprise me if IDEXX loses its market share gradually down the road.
I used IDEXX as an example because I think what happened there is a good illustration of both how a distribution system can give a business great moat and how losing it can narrow the moat significant. In many niche markets, you can find businesses with wide moat because of their distribution network.
