Moat Investing—Knowing the Basics

Warren Buffett on Economic Moats (Source: 2007 Berkshire Hathaway Shareholder Letter)

Figure 1.  ROIC and Competitive Advantage (Courtesy: @mjmauboussin)

A company's moat refers to its ability to maintain the competitive advantages that are expected to help it fend off competition and maintain profitability into the future.

Moat Investing

Moat investing is based on a simple concept: Invest in companies with sustainable competitive advantages trading at attractive valuations. One of the first steps in implementing this approach is finding companies with a moat.  

Earnings must be stable in order to determine valuation. Because valuation is about forecasting the future. When earnings fluctuate, especially when there is no moat, your valuation will be less reliable. This means that companies in the early stage are tougher to value.

Figure 2.  Moat Investing

 

What is the Moat Source?

The below are Morningstar’s 5 sources of moat:^[1]

• Switching Costs
• Intangible Assets
• Network Effect
• Cost Advantage
• Efficient Scale

In this article, we elaborate these 5 moats using what Brian Stoffel have shared on his Twitter account.^[2]

Figure 3.  (MOAT) VanEck Morningstar Wide Moat ETF stock price (Courtesy: stockcharts.com)

Switching Costs

It’s a pain in the butt to stop using a product or service.

Examples

⚫️ Bank. 

I hate my bank. But I have so many accounts and payments linked to my checking account I don’t want to mess with it.

⚫️ Software system (AXON)

Police departments train all officers on one platform to store video, complete paperwork. 

⚫️ NFLX

Becoming less true, but since payments were automatic from credit cards and low, few people cared enough to go about switching.

Key metrics to check

⚫️ Dollar-Based Net Retention/Expansion 

⚫️ Churn 

⚫️ Number of tools per customer 

⚫️ Sales and Marketing as % of gross profit

Pros & Cons

Pro: Locks customers in for life

Con: Can be difficult to win over new customers because they’re likely dealing with same high switching costs from legacy providers

Intangible Assets

Something you can’t touch that provides a company with a semi-enduring edge over the competition.

There are 3 key ones worth looking for:

Example #1

⚫️Brand (Coke KO)

There’s little difference between sugar-water providers. But brand loyalty is enormous.

Key metrics: 

⚫️Gross margins 

⚫️Sales & Marketing as percent of gross profit 

Pros & Cons

Pro: Can last for decades 

Con: Can disappear quickly

Example #2

⚫️Patent

 Any biopharmaceutical company that gets FDA approval

Key metrics: 

⚫️FDA approval 

⚫️Addressable market 

⚫️Sales Growth 

⚫️Length of patent 

Pros & Cons

Pro: Legally protected monopoly 

Con: Most eventually lose patent, newer products can come to market that are better

Example #3

⚫️Gov’t Protection

Energy companies. Localities usually only have one service provider, and are highly regulated

Key metrics: 

⚫️Net margins
⚫️Dividend growth
⚫️Dividend payout ratio

Pros & Cons
Pro: Very reliable and predictable business
Con: Likely slow-growing

Network Effect

Each additional user makes the entire service/product better for existing users.

Examples

⚫️The telephone

Who cares about having one if no one else does?

⚫️Instagram

If you want to be seen, it’s the place to go. Each new user makes it more valuable.

⚫️CRWD

Each new user is a node that allows Threat Graph to get smarter, providing more cybersecurity for existing users.

Key metrics to check:

⚫️Total customers

⚫️Total customers spending X dollars

⚫️Number of tools per customer

Pros & Cons

Pro: When working, it’s a virtuous cycle. Con: When it’s not, can be a vicious cycle of customers FLEEING a service (MySpace)

Cost Advantage

You can offer something (sustainably) for less than anyone else.

Examples
⚫️Walmart

For decades, Walmart’s scale allowed it to negotiate rock-bottom prices from suppliers, and passed that on to customers (Economies of scale)

⚫️Fulfillment (AMZN)

With 350 fulfillment centers in the US, Amazon's 2-day shipping has lower INTERNAL costs anyone

 ⚫️Data (GOOG)

Has 9 products with 1 billion+ users. Don’t cost that much to service, yet provide gobs of data for advertisers.

Key metrics to check:

⚫️Gross Margins

⚫️Sales growth

Pros & Cons

 Pro: Keeps competition away because its expensive/impossible to compete
Con: Can require ENORMOUS up-front costs

Counter Positioning

Competition would be harmed trying to do what you do.

Examples

⚫️AMZN

Changed brick-and-mortar retail networks from assets to liabilities overnight by offering The Everything Store via the Internet.

⚫️NFLX

Blockbuster made $$ on late fees in stores. Couldn’t copy NFLX because pivoting would have been too painful

⚫️TSLA

Selling directly to owners, cut out dealerships and Tesla can offer cars at comparatively cheaper prices (or keep more profits)

Key metrics to check:

⚫️Market share

⚫️Sales growth

⚫️Gross margins

Pros & Cons

Pro: Very reliable and predictable business Con: Likely slow-growing

Figure 4.  Wide Moat Businesses (Source: Counterpoint Global Research)

Figure 5 Top 100 most valuable brands 2022 (source: [5])

Sources of Competitive Advantage according to McKinsey

References

1. What Makes a Moat? Morningstar's Five Sources of Moat
2. @Brian_Stoffel_
3. MOAT Top 10 Holdings
4. What highly profitable business models are dominated by only a few companies (@01Core_Ben)
• Digital Ads: $META, $GOOG, $AMZN, $AAPL (soon)
• Railroads: $UNP, $CSX, $NSC
• Rating Agencies: $MCO, $SPGI
• Cloud: $AMZN, $MSFT, $GOOG
• Exchanges: $ICE, $CME
• Operating Systems (mobile): $GOOG, $AAPL
• OS's (other): $MSFT, $GOOG, $AAPL
5. The Top 100 Most Valuable Brands In 2022
6. ROIC vs Profitability margins
• Margins don't reveal how much investment was needed to achieve them.
• ROIC evaluates both profitability and the capital that was required to achieve them and is a much more comprehensive approach
7. NOPAT margin (%)
• The NOPAT margin (%) is the ratio between a company's net operating profit after tax (NOPAT) and revenue.