Image source: Pixabay

With the market riding pretty high and stock buying opportunities limited, I wanted to take some time to put together a series of articles going a little more in-depth on the GreenDot Stocks investing process.

As laid out in the Help page, we start by using the Green Screens to mechanically filter the entire investment universe of over 5,000 stocks down to just a handful of companies that have strong revenue growth and free cash returns on capital. That gets us started in the right direction.

After that, we want to take a closer look to find in those screens the truly great companies, that would make awesome investments at the right price. While this is part science, part art, in general the diligence process comes down to 4 check boxes. In this series, I'm going to go in-depth on each of these and tell you what to look for to either give a company a "pass" or "fail" on each.

The 4 "Check Boxes"

Those 4 "check boxes" are (articles are linked):

1) Recurring Revenue

2) Long-Term, Organic Revenue Growth

3) A Strong Economic Moat (this article!)

4) Business-focused Management Teams (coming soon)

When a company "passes" all 4, then we move to a stock price valuation - which is separate from business analysis. We can cover that a different day!

Competition: Great for Consumers, A Challenge for Businesses

If there is a single word that describes why the capitalist system has been successful in raising the standard of living for its participants, that word is "competition".

In a free market, consumers are free to satisfy their needs from any provider. They generally choose who to buy from based on a combination of cost, quality, and convenience. Businesses have to constantly strive to provide their products and services based on these factors, better than other businesses offering the same. The rewards for doing so are wealth, economic power, and prestige - some of the most basic of human desires.

Competition is great for consumers. Companies are constantly competing to provide ever better, cheaper, and easier-to-use products and services. This has made things that were once expensive and rare - chocolate, meat, flat screen TVs - abundant and inexpensive.

On the other hand, competition is the main thing that makes running a business so difficult. Your competitors are always trying to steal away your customers, employees, and suppliers with better deals. This tends to both drive down prices and raise costs over time, limiting the potential profitability of your business down to the bare minimum - or worse!

Unless you have some "guard", some "protection", against this competition, it is going to be damn hard to sustain profitability levels that allow you to continue investing in the business to keep it growing.

Do these protections exist? They do! And they are what we (and other great investors like Warren Buffett) refer to as "economic moats".

What Is An Economic Moat?

An "economic moat" (also called a "durable competitive advantage"), is a structural advantage in your business that prevents competitors from easily stealing away your customers.

For example, let's say you are Coca-Cola (KO). Throughout its long history, Coke has faced no shortage of competitors, ranging from Pepsi, to RC Cola, to store brand, not to mention hundreds of other competing "colas" in the early days of its existence. To most onlookers, it would seem that the cola market should be ultra-competitive, with cutthroat pricing that barely allows for profitable margins.

But this isn't the case! At all! Coca-Cola runs operating margins near 30% and converts over 35% of revenues to free cash flow. It is a TREMENDOUSLY profitable business, although its days of heady growth are worn out. Still, the company has actually increased its market share over the past 20 years and still - 137 years after its founding - maintains over 45% share of the international soda industry.

How can this be?

The answer, of course, is that Coke has one of the textbook economic moat factors - an incredible consumer BRAND that buyers simply automatically buy without even looking at competing products.

We will go into more detail on this, but this illustrates the point that a strong economic moat can protect your businesses' margins for decades, even against a gauntlet of new competition. That's why we ALWAYS want to see indications of a moat when we are researching a potential new investment. And we always want to keep an eye out for deterioration of that moat over time.

Let's take a look at the handful of factors that can create a durable and sustainable economic moat for a company.

The Truly Durable Moat Factors

Before we discuss the different moat factors, I would be remiss not to point you to the "father" of economic moat theory, Pat Dorsey, the former Director of Equity Research for Morningstar. His books The Little Book that Builds Wealth and The Five Rules for Successful Stock Investing are the "holy books" on moats, as far as I'm concerned. So check them out!

Now, let's look at the 5 factors that a company can build to protect its business:

Brand: We mentioned this one with the Coca-Cola example. To have a true brand moat, it can't just be name recognition. Ford Motor (F) has strong brand recognition, but zero brand moat. A brand moat must allow one of two things. It can allow a company to charge more for an essentially similar item (like Dior, or Patek Philippe). Or it can act as a "default purchase", where consumers don't even consider anything else when shopping for a certain category of product or service. Firms with incredibly powerful brand moats (like Coke, Proctor & Gamble, or Apple) get BOTH of these advantages, but even one can be quite valuable.

Network Effects: A network effect is when a company has built a network that is so valuable to both buyers and sellers that it would be foolish for either not to utilize it. Every node added at either end makes it ever more valuable to everyone. The credit card networks (Visa (V) and Mastercard (MA)) are good examples. Visa has nearly 3 billion cards issued, making it virtually mandatory for merchants to accept it. And since all merchants accept it, buyers prefer to carry it. The same phenomenon can apply to marketplaces, transport networks, social networks, etc. Once a network is big enough, it is nigh impossible for a competitor to catch up (few even try).

Switching Costs: It is relatively easy to change your streaming provider or your brand of bread. But it is a lot less easy to change your bank, with all of its direct deposit, bill pay, and money transfer connections. For large corporations, often extremely important parts of their business (HR, sales, customer service, etc.) are built on top of a vendor's cloud software service. That makes it very difficult to switch vendors without a lot of time and effort. It isn't worth switching unless the advantages are substantial. This fact can "lock in" clients for decades, as long as the level of service and pricing doesn't far too far off the pace.

Economies of Scale: Traditional businesses like retailers, commodities, or goods producers, can gain an advantage on competitors by owning a tremendous scale advantage. In a business with a lot of fixed costs, volume is critical to generating excess profit margins - in many cases, it only costs a little more to produce/sell a million units than to produce/sell one. That creates a tremendous barrier to entry for new competitors. Some examples here include Walmart (WMT) and ExxonMobil (XOM).

Unique Assets: There are various types of unique assets that a firm can possess that competitors cannot access. These can be government-granted regulatory assets, like patent protection or an exclusive/limited license (pharmaceutical and defense firms are good examples). It could be geographic, such as owning a mine or oil well that is unusually cheap to produce and/or transport from. Or it could just be a combination of these, such as landfills or power plants that are virtually impossible to get approved for new construction. Any of these virtually lock out new competitors from trying to take your profits.

Conclusion

Without a moat, a business will almost certainly see its profits whittled away by competition over time - it is what makes the free market work for consumers. However, by identifying one of the 5 "true" moat factors in a potential investment, we can have reasonable confidence that our company's sales and cash flows can sustain competitive forces for longer than most - perhaps indefinitely!

In the final article in this series, we will take a look at how to evaluate a firm's management - a key factor in how a business will approach future challenges.

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