Moats: Protection from Barbarians at the Gates
Earlier this week we discussed the quality first approach we use in our investment process at Ensemble Capital. In that post we mentioned the concept of a “moat”. Let’s explore this concept a bit more.
In medieval times, moats were the bodies of water surrounding castles used to protect against invaders.
Bodiam Castle, Scotland Source: antarcticaedu.com
In a time dominated by foot soldiers and horses, the moat provided a good defense against the threat of pillaging invaders while allowing the castle’s resources to be channeled towards a limited entry point that made defending it a lot easier. The medieval times were a barbaric period in human history when resources were very limited and it was fair game for one group to try to take them from another to survive, with the strongest capturing or retaining the spoils of battle.
Capitalism is still barbaric. When a company finds a place in the economy to earn a profit, there are many other companies that will try to take a piece of the action. Without some type of profit protecting business model characteristics, businesses with attractive returns are likely to be bled out by competitive assaults until returns fall towards some industry average, resulting in just average profits over the long term.
We see examples of this brutal competition occur in cycles broadly across the airline, auto, insurance, clothing, steel, technology, and most other industries where there exists little differentiation between the products and services beyond some short period of time. Most businesses facing this daily reality will have a hard time earning strong returns and, therefore, represent an average business at best with average investor returns.
Fortunately, there are a select few companies that have managed to build strong defenses around their businesses, either with their own activity, due to the structure of their targeted business/market, or with the help of external forces such as regulation, that enable them to earn strong rates of returns over long periods of time.
The moat analogy has often been cited by Warren Buffett, who has emphasizes the role of moats in his investment selection and acquisition candidates. When his favorite investment horizon is “forever”, it’s the moat (1st) and management (2nd) shepherding the business that deems a company worthy of his ownership (but only if it can be bought at a “fair” price or better). The moat allows the company to earn excess returns in its business while the duration of the moat advantage allows the company/investment to compound the value of the excess returns over time.
Additionally, if a strong moat exists, then any particular quarterly reported number is very unlikely to mean much at all in the overall long-term value of the company, whether positive or negative, despite Wall Street’s short-term excitement over these reports.
The Morningstar team has published a great book detailing how to analyze moats called Why Moats Matter. In it, they cite a wonderful example of Proctor & Gamble’s moat weakening after a new CEO made changes in its R&D efforts beginning in 2000 that resulted in only a 0.7% drop in one of P&G’s most high-profile product categories, laundry detergent, from 2007 to 2012. In other words, the strength of P&G’s moat was so strong that it took five years to lose less than 1% of market share to competitors despite management’s reported mis-execution for a decade! That is the buffer a moat provides a company against encroachments into its high-return turf.
Sources of moats can generally be characterized as:
- Intangible Assets including patents, brands, reputation, trade secrets, proprietary business processes and other sources of advantage that make it difficult for competitors to enter into a market or charge enough to earn a high enough profit or take meaningful share. Classic examples of this are Apple (APPL), Tiffany (TIF), and Pepsi (PEP) among our portfolio names.
- Low Cost/Scale Advantage that allows only a limited number of players in an industry to be the low-cost supplier(s) that then allow these players to enjoy higher profits than competitors because of their wider margins and/or grow to take more of the market profits because they can undercut rivals while still earning profits. Examples of this are retailers like Costco (COST), Amazon (AMZN), and Walmart (WMT).
- High Switching Costs that make it overly costly, risky, or inconvenient for customers to switch from one vendor to another due to the long-term life of products, steep learning costs, a non-insignificant risk of failure with a new vendor, or simply behavioral inertia. Classic examples of these are software vendors such as Microsoft, Oracle, and Apple or mission critical business services like Paychex (PAYX) and Broadridge (BR).
- Network Effect is the phenomenon when the value of a service or product becomes more compelling as more people use it. A great example of this is the telephone and the Internet or a credit card network like MasterCard (MA)/VISA (V) or search/social advertising networks like Google (GOOGL)/Facebook (FB). The more people use the product, the more valuable it becomes to everyone already using it because they get increasing value from it.
- Regulation can provide protection for some period of time either explicitly, as with drug patent regulation, or in a more general way that makes the cost of entry (monetary or otherwise) too high for new competitors. Drug and medical device companies, such as Intuitive Surgical (ISRG), or airplane parts suppliers, such as Transdigm (TDG), get a strong advantage in protecting their businesses as a result of the regulatory approvals competitors have to earn in order to compete.
Ideally, a company has multiple moat characteristics that allow it high barriers across multiple fronts. For example, Apple has trade secrets involved in its design and manufacturing approaches, patents to protect some of its innovations, a strong brand that signals quality and status, scale to exert significant price control over its suppliers and its retail/service provider partners, and high switching costs among its customers who are embedded in its services ecosystem and have learned to habitually use its products. The results speak for themselves.
It’s up to the investor to determine if there exists a moat and what the quality of the moat is for any particular company. The stronger and more durable the moat, the higher the likelihood that a company can earn and compound high rates of return above market rates by fending off competition from eating into its business. This is likely to increase the odds that the investor can earn a better than average long-term rate of return while minimizing risk.
Discovering and evaluating these strong moat companies is the first and most important step in our investment process at Ensemble and we believe it is the key to our long-term investment strategy.
Ensemble Capital’s clients own shares of Alphabet, Inc. (GOOGL/GOOG), Apple Inc (AAPL), Broadridge Financial Solutions Inc. (BR), Intuitive Surgical, Inc. (ISRG), MasterCard, Inc (MA) Paychex, Inc (PAYX), PepsiCo, Inc. (PEP), Costco Wholesale Corp (COST), Tiffany & Co. and TransDigm Group, Inc. (TDG).
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