In chapter seven of “Modern Value Investing: 25 Tools to Invest With a Margin of Safety in Today's Financial Environment,” the subject is business moats. It’s one of the qualitative factors that can be used to analyze risks and margin of safety.
To kick off the chapter, author Sven Carlin invoked two investing gurus: Seth Klarman (Trades, Portfolio) and Benjamin Graham. He first reminded us of Klarman’s dictum: “You want to focus on risk before you focus on returns. A lot of it is focusing on multiple scenarios, what can go wrong? How much can you lose?”
He followed up with Graham, saying readers might be surprised he, Carlin, was discussing qualitative factors while Graham had already set out quantitative terms. He pointed out that Graham’s strategy, elucidated in the 1930s, was based on accounting values. Since much has changed over the past eight decades, there is a need for qualitative as well as quantitative information.
Some metrics affecting margin of safety may not be found in the financial statements, but are critically important nonetheless. They include: the number of users of a new technology, market share, competitive advantages, brand power, the competence of management, geographical locations, legal jurisdictions and more.
Tool 12: A business moat
One of the qualitative factors listed above was competitive advantage, known informally as a moat. Carlin cited the words of Warren Buffett (Trades, Portfolio):
“A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business ‘castle’ that is earning high returns. Therefore, a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing powerful worldwide brands (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with ‘Roman Candles,’ companies whose moats proved illusory and were soon crossed.”
Carlin argued that having a wide moat is a “key margin of safety indicator” and a key to the stability of businesses. While there are no precise measures of a business moat, their size can be estimated. One way to do this is by comparing a business with its competition: Is there a threat to the business being analyzed? The fewer the threats or the lower the magnitude of the threats, the wider the moat.
Buffett and Charlie Munger (Trades, Portfolio) have long been fans of simple businesses they can understand easily. As such, they were frequently criticized in the late 1990s for not investing in the then-burgeoning tech sector. But the big bust that followed made them the gurus to follow again.
In that context, Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) rules out companies in industries that are experiencing rapid and continuous change. As Buffett said, “creative destruction” is a very good thing for society but ruins moats and takes away investment certainty.
Carlin offered this list to help determine whether a company has a moat:
- The company is a low-cost provider or producer. Companies that can satisfy customers while offering the lowest prices obviously have a moat. Two of them were referenced above: Geico (a Berkshire Hathaway company) and Costco (COST, Financial).
- High switching costs, as in the case of Microsoft (MSFT, Financial) and the Windows operating system.
- Network effect, which refers to growing company strength as the number of users or customers grow. For example, Facebook (FB, Financial) and Amazon (AMZN, Financial) enjoy wide moats because they have so many users.
- Brand dominance refers to companies that have not only great product competence, but also the emotional loyalty of customers. An obvious example is Apple (AAPL, Financial) and its devoted customers. Such loyalty allows the company to charge higher prices.
- Reputation, particularly for quality, can create a moat. Carlin’s examples were Google (GOOG, Financial)(GOOGL), Band-Aid (JNJ) and Post-It (MMM). Strong reputations such as these become the default names for product and service categories.
- Economies of scale, in which companies make very large upfront investments and then can make low-cost offerings. Utilities, for example, generally hold such advantages.
- Government protection is one of the best competitive advantages. Companies that have them are often known as monopolies (or duopolies). However, governments can protect companies in their home markets only. In some cases, government protection is not direct and comes from regulations and restrictions that make it hard for new companies to enter markets in areas such as financial services and health care.
In discussing moats, Carlin referenced qualitative factors, as he promised to do. Yet, there are also quantitative factors that can be pulled from the financial statements.
One would be a historical look at a company’s gross or net margins. For example, this GuruFocus chart shows Costco’s net margin over the past 20 years:
Last year, I analyzed several companies using the Macpherson Model; based on the ideas of fund manager and GuruFocus contributor Thomas Macpherson. A key part of this model is the existence of a competitive moat. He uses two metrics to assess moats: 10-year median return on capital (a minimum of 15%) and the 10-year median return on tangible equity (again, a minimum of 15%).
Of course, there are many other takes on moats. Morningstar routinely assesses major companies and assigns a strength of moat rating using both qualitative and quantitative information. For example, “We believe Costco has amassed a wide economic moat stemming from a cost advantage and its strong brand.”
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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