When somebody mentions the term "moat", what comes to mind?
For me (as I'm sure for many of you), I think of the wide, water-filled trenches dug around medieval castles, which drawbridges would drop across to allow entry (hence the name draw-BRIDGE).
Ok, but what does all this have to do with business-focused stock investing?
Quite a bit, to be honest.
In this article, we're going to discuss what an economic moat is, why it is important for business-focused investors, and give an overview of some different types of moats. For those unfamiliar, it will act as an introduction to economic moats. For those familiar with the concept, it can be a refresher. In later articles, we will go into more depth on each type of economic moat, providing examples to illustrate.
Let's get started!
What Is An Economic Moat?
An economic moat is called that because it serves very much the same purpose of the medieval castle moat.
Why did medieval lords build moats around their castle?
For defense, of course! Although castle walls were strong, attackers soon developed effective offensive techniques. Ladders allowed them to scale the walls and rush from within. Battering rams allowed them to knock down walls and doors. Just close proximity to the walls made it harder for archers to defend. Moats solved a lot of these issues and made castles very difficult to successfully attack.
Economic moats provide the same defensive protections in business.
Business is war. I go out there, I want to kill the competitors. I want to make their lives miserable. - Kevin O'Leary, businessman and Shark Tank shark.
Like medieval war, business consists of competitors fighting for resources. In medieval times, it was land. In modern times, it's the customer's money.
Any successful business will spawn competitors. If a gas station opens in a small town, it will do extremely well all by itself. But others will see this, and someone will decide to open one across the street, to get traffic going the other way. While the new station will likely do well for itself, the first will see its business cut in half. If both continue to prosper, you can bet someone else will open a third station down the road at the next intersection.
This is how business works. Competitors will constantly try to take business from each other with all kinds of tactics: product differentiation, price competition, convenience, etc. But ultimately, everyone will catch up to each other. In this environment, profits are slowly competed away, down to minimal levels of sustenance.
It is important to note one thing here: THIS IS GREAT FOR CONSUMERS! It allows them to enjoy excellent service and a wide array of products at very affordable prices. This is a key reason why capitalism works so well as an economic system, raising standards of living very high, even for the least fortunate.
But it can be hell for business owners to stay afloat, over time.
That's why an economic moat is important. It provides some semblance of protection against competitors taking away business. It allows firms to continue prospering, even in the face of new competition.
Why Is An Economic Moat An Important Consideration For Investors?
One of the key tenants to our business-focused investing strategy comes from Warren Buffett's famous quote:
Time is the friend of the wonderful company, the enemy of the mediocre. - Warren Buffett, Berkshire Hathaway CEO and legendary investor.
What this quote means is that companies without an economic moat (mediocre companies), will eventually have their revenues and profits competed away. On the other hand, those with strong economic moats (wonderful companies), will wipe out their competition and continue prospering, generating massive wealth for their investors in the process.
Put simply, without an economic moat, our minimum 3 year holding period would be a very bad idea. With a moat, a long holding period is the key to realizing very reliable investment returns that smash the market at large.
That is why correctly identifying moats and assessing their strengths is absolutely critical to our investment process. It is the most important of the 3 key questions.
The Different Types Of Economic Moats
Several prominent business-focused investors have spent years identifying and describing the different types of economic moats a company can build to protect its business.
Probably the best book I've ever read on the subject is Pat Dorsey's The Little Book That Builds Wealth. There are other, larger books about moats, but this one is the most succinct and useful. Seriously, take a weekend and read it, the concept is *critical*!
Building off Dorsey's and other's work, and simplifying the concept a bit, we believe there are 5 types of moat that reliably protect a business. These are what we look for in every stock review we do:
- Strong Brands. A strong brand can allow two different kinds of protection. Some brands provide only one, some provide both. The first is a perceived value benefit. Here, the brand allows the company to charge higher prices for essentially similar products. Think Apple (AAPL) or BMW. The second is an automatic purchase benefit. Here, customers simply buy a brand they know because it lowers search costs. Why research diapers when you know that Pampers (made by Proctor & Gamble (PG)) are reliably high quality? Or consider buying that new soda brand when you already know Coca-Cola (KO) is delicious?
- Network Effects. A company that has built a strong network provides itself a self-sustaining "flywheel" of business that is almost impossible for new entrants to encroach upon. Take Visa (V), for example. Merchants absolutely HAVE to accept Visa because... all their potential consumers want to use it! At the same time, consumers choose a Visa card over, say, a Discover (DFS) card because they KNOW all merchants accept it! Numerous competitors have tried to take some of Visa's business... and almost all of them fail and end up having to work WITH Visa instead.
- High Switching Costs. If you wanted to switch the supermarket you shop at, there is very little cost to doing so. However, what if you wanted to switch cable TV providers? It's a bit different. You have to research competing options and their pros-and-cons, call customer service and wade through numerous marketing pitches just to get service canceled, take the time to return all equipment, schedule set-up with the new company, get equipment installed, and so forth. It has to be a pretty big advantage offered by the new option to go through all that hassle, right? Now, imagine critical business systems at a large company, and the layers of conservative bureaucracy terrified of making a bad business decision in changing them. Businesses providing services with high switching costs benefit from these dynamics, where existing customers are highly unlikely to move to a competitor. High switching costs are especially prevalent in vendors selling critical, complex systems to large enterprises.
- Regulatory Barriers. Some companies absolutely require government approvals or protections to conduct their business. Pharmaceutical companies are a good example here. Any drug they produce must go through 3 rigorous phases of both efficacy and safety trials. Then truckloads (really!) of data must be prepared and sent to the FDA before the drug can be approved for human use. However, once approved, government-issued patents protect the drug against competition for a period of about 15 years, allowing substantial profits free from competition.
- Unique Assets. My favorite example of a unique assets moat is Vail Resorts (MTN). Think about it - could a competitor really build a MOUNTAIN?! No. Mountains suitable for ski resorts are few and far between, and most good spots are on public lands that the government isn't keen to allow development on. Exactly 5 new U.S. ski resorts have been built in the past 20 years.
We will be adding individual articles going more in depth on each of these moats in the near future. Stay tuned!