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Economic Moats – Part 1 of 3

Like a deep, broad trench that protects medieval castles from invaders, economic moats protect businesses from competitors, allowing them to prosper. In this three part series, I will be sharing why finding economic moats should be central to an investor’s analysis, examples of sustainable moats, where to find them, how to identify them and other intricacies of economic moats.

Why do economic moats matter?

Moats matter for many reasons. First, it allows a company to create more value. As economic moats prevent competitors from stealing their business, companies with strong moats are able to earn greater than average returns on investment and compound money for investors for a longer period of time. In today’s highly unpredictable world, one thing remains certain – businesses will go where the money is. Moats are thus extremely important for highly profitable companies to protect its bottom line.

Placing an emphasis on finding economic moats also enforces investment discipline, making it less likely we will overpay for a hype stock. By forcing ourselves to assess whether a company’s edge is durable, we can prevent ourselves from getting caught in a trap where we invest in a fast growing company whose competitive advantage may disappear overnight.

This brings me to my next point. Investing in companies with economic moats will lower the odds of permanent capital impairment. When a company possesses strong economic moats, it is unlikely that its revenue and earnings will take huge permanent hits due to increased competition. This protects investors from permanent capital loss.

Finally, economic moats help make a company more resilient. As companies launch new growth initiatives, there are bound to be some failures. Even when a new launch completely flops, companies with economic moats are able to fall back on its core business and their ability to generate positive returns will not be severely hindered.

With the points mentioned above, it is safe to say that all things equal, investors should be willing to pay more for a company with an economic moat than one without.

Four commonly mistaken moats

Moats are extremely hard to identify and many investors mis-identify these four characteristics as economic moats. Sad to say, chances are that they will be disappointed as competition increases.

Great products

Great products are very important to win over customers but they are not moats in and by themselves. This is especially so if others can easily copy them.

Strong market share

Bigger is not necessarily better when it comes to digging an economic moat. While there are cases where market share can help build an economic moat, it largely depends on the industry. Kodak (film), IBM (PCs), Netscape (internet browsers), General Motors (automobiles), Corel (word processing software) have shown that market leadership can be fleeting. The question to ask is not “whether a firm has high market share” but rather “how the firm achieved that share”.

Great execution (efficiency)

Being more efficient is an excellent strategy that can help improve profitability by cutting costs. However, unless it is something proprietary that cannot be copied, it is not an economic moat.

Great management

Yes, you don’t want an idiot running the firm but great managers are not economic moats. Managers come and go and as Peter Lynch once said, “go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it.”

Moat 1: Intangible Assets

Brands

Brands are one of the strongest economic moats as they are notoriously hard to replicate. However, a caveat must be said here that popular brands does not necessarily endow it’s owner with a competitive advantage. Brands are only an economic moat if it increases consumers’ willingness to pay or increases customer captivity. For example, Sony is an extremely well known brand but you probably would not spend more on a Sony DVD player than one from Philips, Samsung or Panasonic. On the contrary, many would pay double to get an iPhone compared to other smartphone brands.

The second way brands can create economic moats is by increasing customer captivity. For instance, when you buy a can of coke, you know exactly what you are getting. While The Coca-Cola Company may not able to sell a can of coke for double the price of Pepsi, many people will keep choosing coke over other drinks because of the positive experience associated with the brand.

Patents

While patents can prove to be a very strong economic moat, they have finite life and can be challenged. Furthermore, they are vaguely defined and guessing which team of lawyers will win a patent battle is a game with poor odds. In general, beware of any firm that relies on a small number of patented products for its profits as any challenge may severely harm the company’s profits and will be impossible to foresee.

Patents only constitute a truly sustainable competitive advantage when the firm has a demonstrated track record of innovations as well as a wide variety of patented products. 3M for instance has thousands of patens and hundreds of products.

Otherwise, patents can only serve to give companies a head start to building other more sustainable forms of economic moats.

Regulatory Licenses

This advantage is most potent when a company needs regulatory approval to operate in a market but is not subject to oversight with regards to pricing. Think of utilities versus pharmaceutical companies. Utilities have near monopoly but since water and electricity are basic needs, politicians watch prices like a hawk and it is unlikely that utilities will be able to earn phenomenal returns on equity. Pharmaceutical companies on the other hand, operate in a highly regulated industry but are free to set the prices.

There are two ways to build an economic moat using regulatory licenses, either single licenses or multiple smaller, hard-to-get approvals. The bond rating industry (Moody’s), slot machine industry and for-profit education are all examples of single licenses or approvals. These regulatory licenses are extremely difficult to get, allowing them to earn much greater than average returns on capital. However, this results in an over reliance on that one license. If the government ever chooses to grant more licenses, the profitability of these companies will be severely hindered.

Multiple smaller, hard-to-get approvals thus form deeper and wider economic moats because they are unlikely to all disappear overnight en masse. Common examples would be NIMBY (”not in my backyard”) companies such as waste haulers and aggregate producers – nobody wants a landfill or stone quarry located in their neighbourhood so getting new ones approved is close to impossible. Yet, these markets are highly localised because it is not economical to transport trash hundreds of miles away and trucking aggregates 40 or 50 miles will incur too much cost for producer, pricing them out of the market. This results in a local monopoly.

Contrast this to another industry with strong NIMBY characteristics – refinery. Refined gasoline has a much higher value-to-weight ratio meaning that it can be moved very cheaply via pipelines so distance is not an issue. Thus, this form of economic moat can be found in NIMBY industries that have low value-to-weight ratio (ie transportation costs are high).

Moat 2: Switching Costs

Companies that make it tough to use a competitor’s product or service creates a switching costs. If consumers are less likely to switch, company can charge more, maintaining a high return on capital.

Switching costs come in many flavours and the following is a non exhaustive list:

  • Uncertainty (consumer banks, financial services, asset managers)
  • Highly integrated with a company’s processes (taxation and accounting software, data processers, back-office processing)
  • Retraining costs (Adobe, Autodesk)
  • High upfront costs (healthcare and laboratory equipment)

The issue with finding businesses with high switching costs as an economic moat is that it can be challenging to identify businesses with switching costs unless you use the product yourself as you need to put yourself into the customers’ shoes. Furthermore, consumer-oriented firms generally suffer from low switching costs as you can walk into another clothing store or buy another brand of toothpaste from another grocery store with almost no effort. Businesses marketing consumer goods thus have to compete on economies of scale or brand.

This means that in order to find businesses with high switching costs, investors have to look at other areas such as at the workplace instead of their personal consumption patterns.

So far, we have learnt why economic moats are so valuable, some traps when it comes to identifying economic moats and two forms of sustainable competitive advantage. In the next article, I will be covering another two highly desirable moats that investors should keep an eye out for, stay tuned by joining my telegram channel here!

Posted on by CTKS · 1 Comment

Buy Right And Hold On Or Buy Low Sell High?

Buy low sell high, duh! Everyone knows that that is the way to make money in the stock market. You buy something for less than what it is worth and attempt to sell it at a higher price in the future. Yet, many investors have taken this saying out of context, creating this misguided notion that they have to frequently buy and sell in order to make a profit. They thus end up trading, attempting to make a quick profit. Perhaps the tendency to do so is innate. We all know that dips and corrections are part and parcel of the markets but it remains something that is psychologically challenging to endure. However, studies after studies have shown that the money is in holding on.

The logic behind buying right and holding on is so simple that many belittle it. When you invest in a great business capable of generating greater than average return on investment for many years, time is on your side. Simply holding on will allow your investment to compound.

I recently read “100-to-1 in the stock market” by Thomas W. Phelps and “100 baggers” by Christopher Mayer, two books analysing 100 baggers. A 100 bagger is a stock that has appreciated a 100-fold. Thus, a $10,000 investment will turn into a million dollars. My initial reaction is that stocks like this must be few and far between. I was proven wrong.

In “100-to-1 in the stock market”, Thomas W. Phelps found that starting from 1932, a different stock could have been bought in each of thirty-two different years and every dollar invested would have grown to $100 or more by 1971. In fact, from 1932 to 1964, more than 365 different securities appreciated a 100-fold or more in four to forty years.

At this point, I was of the opinion that technology has advanced by leaps and bounds since then and there is not much left to invent or innovate. Thus, such monstrous growth enjoyed by companies of the past is unlikely to repeat itself.

I was proven wrong once again, and happily so. In his book “100 Baggers”, Christopher Mayer again found more than 365 different 100 baggers from 1962 through 2014. The important lesson to draw here is not that we missed another 365 opportunities. Instead, it is that as long as humans remain humans, the world will keep changing. Consumer trends will constantly evolve, leading to new unmet demand which require new inventions and innovations, creating the next generation of 100 baggers.

Additionally, both books detailed 100 baggers in a wide variety of industries, not just in emerging sectors such as technology, internet and biotech but also in “boring” and “old-school” industries such as consumer businesses. While it may be hard to fathom that there are that many future 100 baggers, history has shown that they are out there, waiting to be found.

If you are convinced that there are many future 100 baggers out there waiting to be discovered by those who seek them, here are a few qualities of 100 baggers to aid you in your search.

1. Growth, growth and more growth

There is no way around it. For the share price of a company to appreciate a 100 fold, it’s earnings has to increase tremendously. So, you need growth – and lots of it. But not just any growth. You want quality, value-adding growth. You want to avoid companies that doubles it’s earnings but also doubles the total shares outstanding. In other words, focus on earnings per share instead of raw earnings. At the same time, beware of companies that increase sales by cutting prices or acquiring companies for inflated prices. Both of these drive down return on equity – the company is investing more and getting back less. These are kind of growth you want to avoid. Focus on companies that has lots of room to expand and reinvest its earning. Such companies will be able to compound earnings over an extremely long period of time. These qualities will show up in the balance sheet as high organic growth (growth without acquisition) and high return on investment.

2. Lower multiples and smaller companies preferred

Growth is only one part of the equation. The other half of the DNA of a 100 bagger is a huge increase in earnings multiple. For instance, if price-to-earnings (PE) ratio remains the same, earnings will have to increase a 100 fold in order for the company to be a 100 bagger. However, if PE ratio quadruples, earnings only need to increase 25 fold. Now that is a much more achievable feat. Together, lots of growth and a low multiple forms the twin engine of 100 baggers.

Along a similar note, smaller companies are preferred. Big tech do have decent growth rates but do you think they are able to grow to a 100 times? Probably not. Apple, as great as it has been and is, won’t become a 100 bagger from current levels. At a 100 times of today’s value, Apple’s market cap will be more than 12 times the size of the US economy. It could be a good stock for some time yet, but eventually, the law of large numbers start to work against you. That being said, you don’t have to go looking at penny stocks. Mayer found that the median sales figure of the 365 names in his study was about $170 million. As a rule of thumb, he recommends focusing on companies with market caps of less than $1 billion.

The caveat here is that while lower multiples and smaller market cap are preferred, they are by no means a prerequisite. There are certainly many great businesses that have higher multiples (and justifiably so). This does not make them poor investments. On the flip side, there are many companies with low multiples because they are declining. Beware of these value traps. Similarly, there are many great companies with market caps above $1 billion that have the DNA of a multi-bagger. The point I am trying to make here is that nothing is cast in stone. Always make your own judgement.

3. Economic moats are a necessity

100 baggers are requires a high return on capital for a long time. A moat will keep competitors at bay, allowing the company to compound it’s earnings at above average rates for a long time. Without moats, competitors will steal away market share, driving return on investment down. Thus, extraordinary growth rates without moats are simply unsustainable. A company with a great product but no barriers to entry may be able to return double or even triple one’s investment. However, they will rarely return much more than that. It thus pays to spend some time thinking about whether the company in question possess economic moats. A moat, no matter how narrow, is a necessity.

4. Owner-operators preferred

Although not a necessity, it does help to have a owner call the shots as well. A CEO with some skin in the game will have his/her interest aligned with yours. What’s good for them is good for you, and vice versa. You can thus have greater conviction that they won’t take actions that allow them to gain at your expense. You can figure out how much stake the executives of a company has in it’s proxy report. I recommend that you spend additional time to do some research on whether the shares that the executive owns are mainly options given to them or common stock that they have purchased. The common wisdom is that options will align the interest of the management team with that of the shareholders. I won’t dive into details, but fixed price options with a long expiration date have the potential to distort the management’s interest. It is best if management own commons stock, and even better if they have to fork out their own money to buy them. That being said, there are many 100 baggers that are not owner led. Having an owner-operator is just an added benefit that gives you conviction to hold on through thick and thin.

Of course, finding a 100 bagger is easier said than done. However, even if I do not find a 100 bagger, I am optimistic that this search will turn up some decent multi-baggers, making the effort more than worthwhile. Nonetheless, 100 bagger or not, the most crucial step in the search for multi-baggers is to hold on.

“To make money in stocks you must have the vision to see them, the courage to buy them and the patience to hold them. Patience is the rarest of the three.”

Thomas Phelps

There is no use in buying right if one does not hold on.