Building a Fortress: Finding Companies with Intangible and Tangible Moats
The graduating college class of 2003, of which I was a member, carries the (fortunate) distinction that it was the last class to go through all four years of college without Facebook.
A year after graduating, I heard college students with .edu email addresses loved a site called Facebook. Us “olds” were relegated to using MySpace, which, to its credit, was the dominant social media network of the time. Indeed, at one point in 2006, MySpace was the most popular website in the US. Not bad for a company that was founded just three years prior.
And yet. The floodgates opened once Facebook opened its doors to non-college students, and MySpace drifted into obscurity. The moat that MySpace was building through network effects unraveled.
So it can go for companies that rely on intangible assets. Without some structural advantage to accompany it, there isn’t much stopping the proverbial kid in a garage – or a Harvard dormitory, in this case – from disrupting the business.
The opportunities and risks associated with the rise of intangible asset-based businesses prompted a June 2021 paper by Michael Mauboussin and Dan Callahan. They concluded: “The good news is that intangible-intensive companies can grow faster than their tangible counterparts. The bad news is they can also become irrelevant and shrink fast.”
As we wrote in our 2018 post “Seeking Unpredictable Value Creation,” there’s a lot to like about intangible asset-based companies. Among other advantages, they are much more likely to produce value in unexpected ways. Bubble Wrap, for instance, was initially marketed as wallpaper and later insulation before it revolutionized the packaging world when it was used to protect computer shipments. Conversely, an old factory might be repurposed as a microbrewery or warehouse residential lofts, but its subsequent growth rates will not be exponential.
Here’s a quick framework for thinking about the tradeoffs between tangible and intangible asset advantages. Note these are general guidelines and not meant to be prescriptive.
|Unpredictable value creation potential
|Pace of change
This post isn’t intended to illustrate how intangible asset-based businesses are risky or their advantages fleeting. As we highlighted last year in our post, “When the Moat is in Your Mind,” some intangible assets like nostalgia-based brands can endure for generations.
Instead, we want to show here the important role both types of assets play in determining a company’s competitive advantage period, or the period in which a company can outearn its cost of capital. More specifically, we get very interested when a company has tangible and intangible asset-based moat sources yielding both cost and differentiation advantages.
One of the key insights we developed when researching Chipotle, for example, was that it had established a national, responsibly-sourced, fresh food supply chain via 24 independently-owned and operated regional distribution centers, making it even harder for a fast casual Mexican cuisine competitor to disrupt its growth trajectory.
No other quick-serve restaurant is close to matching Chipotle’s fresh food supply chain and we believe it would take hundreds of millions of dollars and at least a decade to replicate – an investment most companies would not want to or be able to make. According to Chipotle, the majority of its restaurants are located within 80 miles of a distribution center, and in 2022 the distribution centers locally sourced approximately 11% of the company’s total produce.
At Home Depot’s recent investor day, they shared that the “overwhelming majority” of North American households live within 10 miles of a Home Depot store, 90% of which they own. That physical network of stores is economically out of reach for any would-be competitor over a reasonable timeframe. The network also allows Home Depot to compete more effectively with potential e-commerce rivals by being a more convenient place to acquire items, especially when a tool or material is immediately needed on a project.
As for the supply chain that fuels both its physical and e-commerce business, Home Depot shared at investor day that it took them over 15 years to build out and modernize it. A select group of companies has the financial wherewithal to replicate that investment; none are laser-focused on home improvement retail.
Homebuilder NVR has nine manufacturing centers dotted across its 15-state footprint east of the Mississippi River, which allows it to build roof trusses and wood framing indoors 365 days a year. On the other hand, most homebuilders have raw lumber shipped to be constructed on each job site.
NVR’s communities are mainly located within a 100-mile radius of its manufacturing centers and they supply 90% of the communities with the biggest exception being Florida, where block framing is more common than lumber. This allows NVR to turn its inventory faster than its competitors, who typically operate as general contractors rather than home manufacturers, and ensure quality control before the house is on site.
Ultimately a moat, whether it’s intangible or tangible asset-based, provides a company with time to adjust to changing economic circumstances. There can be times when a company’s intangible assets are struggling and its tangible assets help sustain the cash flows necessary for the company to reposition itself. Indeed, this dynamic helped Chipotle emerge from its foodborne illness crisis almost a decade ago.
The same can be true in the other direction. One of the reasons Starbucks (which we do not own in the portfolio) was able to take the time to reinvent its US store footprint from one dominated by large spaces with couches and fireplaces to one more digitally- and drive-thru based was that its brand and products remained highly relevant to its customers.
While intangible assets can provide more growth opportunities than tangible assets, tangible assets can take longer to replicate and represent an additional barrier to entry for would-be competitors. Both have trade-offs, risks, and opportunities. At Ensemble, we are particularly interested in companies with both intangible assets that create differentiation and tangible assets that provide cost advantages. This combination is a recipe for a wide, durable economic moat that enables companies to generate high returns on invested capital for a decade or more.
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