In the previous articles on economic moats, we learnt how companies can create lasting competitive advantages and why it is important to invest in companies that possess these. In this final article of the series, I will be sharing where to find economic moats and other pertinent things to look out for.
One of the biggest advantages being a retail investor is that we can invest our money wherever we prefer. We are not forced to invest in industry A or industry B so we are free to ignore what we don’t like and buy what we do. This is especially important if we wish to build a portfolio of companies with economic moats because it is a lot easier to dig a moat in some industries than others. Some industries are brutally competitive while others are less competitive and able to sustain solid returns on capital. That’s the reality of life, the economics of some industries naturally support economic moats while others do not.
In technology, software companies tend to have an easier time creating moats than hardware companies. This is not simply an accounting issue but has a strong basis on the way these two broad categories of products are used. A piece of software often needs to be integrated with other pieces of software to work properly, which leads to higher switching costs.
Companies that cater directly to the consumer, like restaurants and retailers, often have a very hard time building competitive advantages. With low switching costs, customers can simply walk down the street with minimal effort required to look for a better deal. People often confuse trend and hype for economic moats. However, investors should be wary because it could very easily be copied or fall out of favour.
On the other hand, companies that provide services to businesses have a much easier time creating economic moats. This is because they are often able to integrate themselves with their clients’ businesses, creating high switching costs and pricing power.
Another thing to note here is that moats are absolute, not relative. The fourth-best company in a structurally attractive industry may very well have a wider moat than the best company in a brutally competitive industry. Hence as intelligent investors, we don’t have to invest in every part of the market. Simply go where the money is.
Measuring a company’s profitability
Now that you know where to look for economic moats, what is the best way to measure a company’s profitability? In order to do so, we have to look at how much profit the company is generating relative to the amount of money investing in the business.
Investing in a company is similar to investing in a mutual fund. A mutual fund takes investors’ money and invests it in stocks or bonds to generate a return, and a mutual fund with a 12 percent return is going to compound shareholders’ wealth faster than a mutual fund with a return of 8 percent. Companies are similar. A business that can generate huge returns relative to the investments made is going to compound money for shareholders much faster than a capital intensive business that generates mediocre returns.
The first method to measure return on capital is using return on assets (ROA). Very broadly speaking, a non financial company that can consistently generate an ROA of 7 percent is likely to have some kind of competitive advantage. However, this metric works well if a company’s balance sheet is purely assets, but many firms are at least partially financed with debt, which give their returns on capital a leverage component that we need to take into account.
The next metric is return on equity (ROE). ROE measures the efficiency that a company uses shareholders’ equity. However, one flaw of ROE is that companies can take on a lot of debt to boost their ROE without becoming more profitable. Thus, it is a good idea to look at ROE alongside how much debt a company has (debt-to-equity ratio). As a rule of thumb, companies that can consistently crank out ROE of 15% without excessive financial leverage is likely to have some form of economic moat.
Finally, there is return on invested capital (ROIC), which is the best of both worlds. It measures the return on all capital invested which includes both equity and debt, thus removing the distortion that debt can have on ROE. As with ROA and ROE, a higher ROIC is preferable to a lower one.
Management and moats
This may sound counter-intuitive but management does not matter as much as we may think when it comes to building economic moats. While we can all remember companies such as Starbucks that managed to dig an economic moat in brutally competitive industries, these are the exceptions rather than the rule. When it comes to whether a company has an economic moat, the competitive dynamics of the industry will have a greater impact than any managerial decisions.
This is not to say that the quality of the management does not matter. Great managers can add value to a business and I’d much rather have intelligent capital allocators at the helm than a bunch of clowns. But the truth of the matter is, management itself is not a sustainable competitive advantage. Managers come and go but companies in a tough industry are stuck there.
The bottom line is that we should bet on the horse, not the jockey. The quality of management matters but far less than economic moats. As Warren Buffet puts it, “When management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”
Finding a great company with strong economic moats is not the end of the process. We have to continuously monitor the business performance as there are a number of ways that moats may be eroded.
- The first way that a company may lose its competitive advantage is if it loses the technological race to stay on the cutting edge. Most technology companies have a hard time building a lasting competitive advantage because of how fast technology advances. As long as they do not continuously innovate and improve their offerings, a better product will eventually breach their moat.
- That being said, technological disruption can pose as a threat to non-tech companies as well and can occur at the most unexpected moments. This is because these companies can look like they have a strong moat before a technological shift permanently hurts their economics. Think about Kodak, which for decades dominated the market for analogue photography, and which today struggles to compete against digital cameras. A similar story can be told for newspapers vs the internet.
- Shifts in the structure of industries
- Consolidation of a once-fragmented group of customers can also harm economic moats because it increases their bargaining power
- Entry of low-cost workforce
- Entry of irrational competitor/government-linked entity
- Bad growth. This is used to describe company ventures into areas outside of its expertise that are unsuccessful. This inefficiency of capital allocation brings down their return on capital, making the company less attractive as an investment.
These developments will result in increased competition and reduced pricing power. The end result is that the company will have lower profitability and returns on capital. Therefore, one useful sign of moat erosion is when a company that has regularly been able to raise prices starts getting push back from customers.
Competitive analysis of a company
Finally, I would like to leave you with this three step process that Pat Dorsey, a guru on economic moats, uses to determine whether companies have moats. His book, “The Little Book That Builds Wealth” has been a tremendous inspiration for this series and I’d definitely recommend picking it up if you’d like to learn more about economic moats.
- We want to look at returns on capital over as long a period of time as possible, as a poor year or two does not disqualify a company from having a moat. If the company has not earned decent returns on capital and the future is not likely to be appreciably different from the past, there is no moat. After all, a competitive advantage should show up in the numbers, and a firm that has not yet demonstrated the ability to earn a greater than average return on capital is a long shot that we shouldn’t bet on.
- Step two is trickier and involves identifying a competitive advantage. This is a challenging but crucial step because it is entirely possible that even a company with a record of good returns on capital might not have a moat. In such a case, the company’s profitability can very quickly fall off a cliff if the trends change or competitors copy them. If we didn’t think about why high returns will stay high, we would just be driving by looking in the rearview mirror, which is rare a good idea. Thus, it is necessary to think carefully about what exactly the company’s competitive advantages are and how it will keep competitors at bay. Knowing this will allow us to tell if the firm’s economic moat has been breached.
- Once we have identified the competitive advantage that allows the company to generate greater than average returns, we have to figure out how durable that advantage is. Because this is more of a craft than a science, we shouldn’t try to slice things too finely. Pat Dorsey recommends dividing companies into just three categories: wide moat, narrow moat, and no moat.
In this series, I have explained what economic moats are, why they matter and how to identify them. I hope that you will be able to apply these pointers to your investment analysis and that they will help you make wiser investment decisions and become wealthier.