First You Get The Moat, Then You Get…
I’m not kidding when I say that millions of people tune into the Warren Buffett and Charlie Munger yearly address in Omaha.
Buffett said in his 2017 letter to shareholders that 17.1 million people watched various parts of the Berkshire live stream on Yahoo! You can find the video here (tip: take an extended lunch break — it’s ‘only’ 7 hours long).
The lucky Berkshire faithful are the ones who travel to the city to see and hear Munger and Buffett speak in person.
However, despite their growing audience, one fact remains: there will only ever be one Buffett and one Munger.
Indeed, while most of us can make sense of the duo’s investing strategy, using it can be more difficult and the practical details too often get lost.
Of the Buffett and Munger four-point checklist, I would argue that the hardest part to master is understanding whether or not a company has a ‘competitive advantage’.
What’s a competitive advantage?
A competitive advantage is a feature of a business that gives it the ability to make more money than its competitors for many years. It’s not a fad or quirky product (remember Fidget spinners?)
It’s an enduring feature of a business that protects it and its profits from being quickly eroded by competitors.
Competitive Advantage = “Moat”
I’m going to use the word “moat” instead of competitive advantage because it makes more sense to me.
When most people think of the word “moat” they think of a murky ring of water around a medieval castle.
In the good old days, the water would protect the castle (aka the company’s profit) from attack.
Soldiers in armour wouldn’t be able to swim across the moat, so just reaching the castle was difficult.
However, this defensive feature wasn’t bulletproof (for lack of a better word). Armies could camp outside the moat and wait for the castle’s supplies to run down. The castle might also be attacked from a distance.
So while the ‘moat’ was a tool to protect a castle from being overrun in the near future, it wasn’t perfect and often wouldn’t last forever (see the charts below).
The moat would buy the castle some time and may even fend off weaker enemies, but it couldn’t stop everyone forever.
It’s the same way I think about a company’s moat, which might be its brand, a patent, location, technology or a cost advantage.
Basically, if a business has a ‘moat’ around it (e.g. a strong brand like Coca-Cola’s), it will have some protection from competition for a period of time. After all, Coca-Cola is the only Coca-Cola. Where else can I find 7 teaspoons of sugar wrapped in aluminium?
If a castle’s moat dries up or disappears (e.g. if the King or Queen decide to widen the moat without adding more water) their castle would quickly come under siege.
In business, think of a CEO who tries to grow a business outside of its core operations or fails to reinvest in the best business to maintain market share.
Who cares about moats?
Some moats can stay in place for years.
This allows a company to make a better return (commonly called return on capital or “ROIC”) for every dollar it spends for a longer period of time.
A moat matters because it means the company can reinvest in its business and earn more money than its peers. Look at the chart above and imagine the ‘value’ is the size of the coloured triangle.
Alternatively, write this on your cheat sheet: “moat = more $$$ for less”.
For example, each time $1 is earned by a company with a moat it can be reinvested to make $1.50, $2 or even $5.
The moat simply means that competitors cannot easily come and take those profit margins away from the company — at least in the near future.
From a long-term investor’s perspective, a wide moat means you might make money even if the shares are not ‘cheap’.
Think about your place of work and if you use a piece of software that handles, say, your billing, payroll, HR, customer management and finance. How hard would it be to change that software?
Likely answer: damn hard.
The software company which supplies that service to you could raise its prices and you (or your boss) would still stump-up the cash for the software. That’s because the software saves time and money for the company.
Even if a cheaper competitor came along, it would be very hard to change, possibly risky for the business and likely not worth the effort.
Therefore, the software company has at least some ‘moat’ to protect its business from competition.
“I can’t get no… moat”
Now think of a business without a moat.
Think of three cafes built right beside each other.
They all have similar costs. For example, the cost of coffee and milk is comparable for each of the cafes.
While one cafe might have slightly better food or coffee and be ‘trendy’ after it opens, each cafe is selling the same product.
That’s not to say the cafes and restaurants cannot develop a moat (just look at Starbucks andMcDonald’s!).
However, if one of these no-moat cafes wanted to increase their prices regularly, the customer would eventually notice the price change and go to one of the competing cafes.
Customers are not compelled to buy that cafe’s coffee, unlike the products from the software company.
Ultimately, it means the cafes couldn’t earn massive profits for many years on end.
Introducing, Mr Moat
The video above shows a Google Talk presentation by Pat Dorsey, of Dorsey Asset Management. Dorsey has done an incredible amount of work on different types of moats.
Without ruining the video for you, Dorsey outlines four common types of moats which could be profitable for long-term investors:
- Intangible assets: think of brands, patents and licences. These moats enable a business to charge the customer more for a product, or the moat protects the business from intense competition. Think of Tiffany’s and Zamels. They sell virtually the same product, but one of them comes with a $10,000 cardboard box!
- Switching costs: This keeps the customer paying. Think back to our software example. Dorsey uses another example in elevators, with ongoing maintenance contracts. How hard would it be for an apartment or office building owner to rip-out an elevator because the servicing costs were too expensive?
- Network Effects: Ever heard of Facebook or Visa? Yeah, me neither… But, seriously, having more people use a network can make it much more profitable. For everything else…there’s Mastercard.
- Cost advantages: This makes it easier to deliver a product for less. If a company has lower ongoing manufacturing, transport or sourcing costs than its competitors, it may be able to earn more profit.
These are just some competitive advantages or moats. Dorsey goes into detail about each of them in the presentation above.
I think it’s a… moat!
Once you find the moat it doesn’t end there. According to Dorsey, an investor needs to:
- Find a company with a moat, then
- Determine if the company has room to re-invest in its core business and grow
- If it can, Dorsey says it may be worth paying a higher asking price to make the investment
Central to the idea about moats is knowing what we want from our investing.
If I want to buy and hold a company for many years, I may as well find a company that can protect itself from all-out competition; be willing to pay a higher price for its shares, and hold on.
(for finance nerds like me, it means we benefit from the compounding of intrinsic value — not only the closing of the gap between price and value)
If a company does not have a competitive advantage it’s a different type of investment. It would probably be a shorter-term investment which I’ll have to monitor more closely.
That’s because the business would be low quality and may even be getting less valuable over time.
For example, Warren Buffett has said before that airlines are tough businesses. That’s because many airlines have the opposite of a competitive advantage.
As Richard Branson, the founder of Virgin famously said:
“If you want to become a millionaire, start with a billion dollars and launch an airline.”
Cheers to our financial future!
Founder, The Rask Group
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