What are Moats?
Moats were useful in ancient times to defend a castle from adversaries. It is defensive work that makes it harder for attackers to infiltrate the caste. (Economic) Moat is an expression used in the domain of value investing describing specific features protecting a business from competitors.
Why Neccessary?
The reason for moats has not changed so much thoughout history, they are built protection. If capitalism works, profitable businesses and industries attract competition. These competitors will try to conquer steal market share and ultimately profits from (unprotected) profitable businesses. This is why highly profitable businesses tend to become less profitable over time. Obviously, we would like to invest in businesses that have economic moats or competitive advantages.
Sources of Moats
Usually moats are grouped into a few categories give or take. Pat Dorsey (former head of equity research at mornigstar) uses these four kinds of economic moats (described in more detail here at google and here at an investment conference).
Intangible assets can give you pricing power. More precisely, valuable intangible assets can be brands, patents or regulatory approvals and licenses. But not every brand equals a moat. The brand has to result in pricing power.
High switching costs also give you pricing power over existing customers. If switching costs are (too) high, existing customers will just stick to your product and pay a slightly higher price year after year, since the product provides a high benefit/cost ratio to clients. Switching costs can be measures in terms of time, money, resources and risk.
Network effects are a very powerful product feature. They increase the value of a product to its customers the more customers use the product.
Cost advantages, in many cases tend to be not that durable. It is important to differentiate between process-based cost advantages and scale-based cost advatages. The latter tend to have a longer lifetime (processes get copied).
Efficient scale is a fifths kind of moat and is mostly found in niche markets. Sometimes there is an established equilibrium in a (niche) market that supports the prevailing number of companies in that market with above average profit margins. Even if capitalsim works, this does not (have to) result in higher competition, if a potential entry of a new player would drive returns below acceptable levels for everyone company involved, including the newcomer. Pipelines, railroads, and ports could serve as vivid examples here.
Duration of Moats
Lengthening a businesses growth period might be possible making use of competitive advantages and thus enhance intrinsic value, as Prof. Damodaran explains.
Estimating the duration of a business’ moat is everything but easy. But I imagine, merely thinking about and formulating a rough answer to the question ‘How likely is it that the moat be intact in 10 years?‘ yields valuable qualitative insights and is key questions at ensemble capital when assessing conviction.
There are two forces determining a moats duration. The group of external threats includes growing competition, more founded start-ups, emergence of new technolgies, growing supplier power and lower buying power. But often moat erosion starts behind the castle walls. Such internal threats include too little R&D efforts (expenses), technology or talent acquisitions; depressed levels of long-term investments or capital expenditures (CapEx); lost customer focus; or lost interest in driving improvements of the companys (core) products and turf wars prevailing in mature businesses: innovation vs legacy cash cows.
Moats and Capital Allocation
The value of a company’s moat is largely dependent on the ability of the business to reinvest cash at high returns, as Dorsey explains here. It is about high incremental ROIC, as explained here by Fred Liu from Hayden Capital. There are different kinds of moats with huge implications on capital allocation decisions and future earnings potential, summarized in how moats make a difference.
Companies that do have no moat or very narrow ones are out of this scope.
Companies with legacy moats without reinvestment opportunities can only use their excess-cash for (i) paying high dividends to shareholders, but beware when dividends are a problem or (ii) use it opportunistically for value creating acquisitions and buying back shares at cheap prices. Such a moat is not very valuable but it narrows the range of potential outcomes and adds certainty, confidence.
Companies with reinvestment moats use their cash generated from operations for reinvestments, growing their business while insulated from competition. If they can do that at high incremental ROICs for a long time such a moat is extremely valuable.
Capital light compounders are companies with strong moats, growth potential, but with limited needs for reinvesting capial, setting the stage for very strong future returns.
Analysis of Moats
Moat analysis changed over time because, as Todd Wedding from Ensemble Capital describes in the evolution of moat analysis, a few decades ago the primary problem was to acquire funding for a business and access to capital (or competitors lacking this valuable access) resulted in barriers of entry. Nowadays intangible assets are often more important and more valuable than tangible assets. Focussing on price-to-book or P/B ratios might therefore be out of time.
Moat analysis is qualitative work. There are no shortcuts to screen for good moaty businesses which might give us an edge against the machines (and quants). I plan to focus more on analysing the moat(s) of a business.
To be continued …
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