Moats

Companies are big machines that take in capital, invest in products or services and earn a decent return on the capital. Good businesses generate a decent return on capital. Companies that generates high return on capital will attract competition. In order to protect the high returns on capital the companies should have structural competitive advantage. Warren Buffett refers to this concept as Moat. In the 2007 letter to shareholders he writes

A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the low cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed. Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.

Why are Moats important?

Imagine you own a business that earns 100% return on the invested capital. Capitalism guarantees that competitors will emerge like bees to honey and will try to take away your market share. Moats are structural characteristics of the business that will create barriers for the competitors to enter into your turf. Warren Buffett writes

The most important thing to me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.

What are the moats?

In the book The Little Book that Builds Wealth – Pat Dorsey discusses about four Moats.

1. Intangible Assets
2. Customer Switching Costs
3. Network Effects
4. Cost Advantages

Pat Dorsey writes

If you can find a company with solid returns on capital and one of characteristics, you’ve likely found a company with a moat.

In this post I will be referring to the examples from this book The Little Book that Builds Wealth.

1. Intangible Assets

Brands, Patents and Regulatory Licenses belongs to this category.

1.1 Brands

Brand creates an economic moat only if it makes the customers to pay more for the product or if it increases customer captivity. Sony has a powerful brand. But why would you pay a higher price for its DVD which is a commodity? In Sony’s case the brand does not create a moat.

Tiffany designs, manufactures and sells its jewelry product worldwide. It charges its consumers a lot more on average for diamonds with the same specification as those sold by its competitors. It charges around 35% more than its competitor Blue Nile for the same product specification. Why? Tiffany brand is very powerful and they come in a pretty blue box.

See’s Candies is another example of powerful brand. Warren Buffet about See’s Candies

There was something special. Every person in California has something in mind about See’s Candies and overwhelmingly it was favorable. They had taken a box on Valentine’s Day to some girl and she had kissed him… See’s Candies means getting kissed. If we can get that in the minds of people, we can raise prices.

Brand are very powerful and it helps us to create strong associations in our minds. Remember the Pavlov Dog? We associate brand with quality and hence we pay up for the products.

1.2 Patents

Patents will prevent the competitors from selling your products. There are few challenges with the patents

1. Have a finite life.
2. Can be challenged by the competitors.
3. Can be revoked.

Pat Dorsey writes

The only time patents constitute a truly sustainable competitive advantage is when the firm has a demonstrated track record of innovation that you’re confident can continue, as well as a wide variety of patented products.

3M is an excellent example of this with a wide moat. It has thousands of patents on hundred of products. A Post-it note is a piece of paper stationery with an adhesive on the back, designed for temporarily attaching notes to documents and other surfaces. This product was invented by 3M. This product was produced only by 3M until the patent on this expired in 1990s.

Charlie Munger in Elementary Worldly Wisdom writes about patents

In microeconomics, of course, you’ve got the concept of patents, trademarks, exclusive franchises and so forth. Patents are quite interesting. When I was young, I think more money went into patents than came out. Judges tended to throw them out—based on arguments about what was really invented and what relied on prior art. That isn’t altogether clear. But they changed that. They didn’t change the laws. They just changed the administration—so that it all goes to one patent court. And that court is now very much more pro-patent. So I think people are now starting to make a lot of money out of owning patents.

1.3 Regulatory Licenses

Government licenses are required to start certain kinds of businesses. Bond rating industry is one such example. In order to provide bond ratings in the United States, the company has to be granted Nationally Recognized Statistical Rating Organization. This is not easy to get and hence it will be a huge barrier to entry for the competitor.

Moody’s Investor Service is one such example. The company has an operating margin of 50% and return on invested capital of around 150%

Pat Dorsey discusses about companies that rely on hundreds of municipal level approvals will create an enormous moat.

Trash and gravel may not sound exciting, but the moat created by scores of mini-approvals is very durable. These companies rely on hundreds of municipal-level approvals that are unlikely to disappear overnight.

Waste Management falls into this category. It provides waste management services to residential, commercial, industrial, and municipal customers in North America. It is not easy for the competitor to enter into this business. Why? The competitor will get tired to get hundreds of mini approvals that are needed. This is also a time consuming process and there is no guarantee that the approvals will be obtained.

2. Switching Costs

For the last 8 years I have not changed my bank. There are banks that offers better interest rates than the one that I am currently with. Bank is a commodity and it is very hard to differentiate on their service. It would take only few minutes to create a new account in another bank. There are several reasons why we do not switch bank accounts.

1. You need to inform your company payroll department about the new bank account. They might make a mistake and your pay check might not arrive on time.
2. You need to setup all your bill pay accounts once again with the new bank and it is a time consuming process.
3. You need to update your mortgage records with the new bank information.
4. We prefer to keep things the way they are. Status quo bias from psychology is another reason.

Pat Dorsey writes

The average bank in the United States earns a return on equity of around 15 percent.

As you can clearly see there is a cost associated with switching banks. This is a huge competitive advantage and an enormous moat.

Asset management and Mutual fund companies also enjoy this moat. Pat Dorsey writes

Back in financial services, asset managers have switching costs that are somewhat analogous to those of banks. Money that flows into a mutual fund or wealth management account tends to stay there – we call these sticky assets – and that money generates fees for many years. For example, during the market timing scandals in the mutual fund world, even when some asset management firms were caught doing blatantly illegal things, most retained enough assets to remain solidly profitable, despite legal costs and investor redemptions.

Oracle is a software company that sells database software. Companies use its database to store data about their businesses. Moving to a competitor database is not easy because

1. The data needs to be copied over to the new database without any errors.
2. All the programs which analyzes and process the data from the database should be rewritten. This is a time consuming and an error prone process.
3. If a proprietary feature of oracle is used then it has to be rewritten using the feature in target database.
4. Need to have a downtime which will impact the business.

Oracle’s average return on capital for the last 10 years is around 20%

Personally I have done several migrations off of Oracle database and I know how hard it is to get this right.

3. Network Effects

Lots of people use Microsoft Office products. Why? Because lots of people use Microsoft Office products. People use a product or service because others also use the same. Open Office is a free product from the competitor. Even a product offered for free could not take away the market share from Microsoft. This shows the power of network effects. Pat Dorsey writes

Network based businesses are more common among business based on information or knowledge transfer than among business based on physical capital. Why?  Information is a non rival good. Most goods can be used by only one person at a time. If I buy a big earthmover from Caterpillar, no one else can use it while I’m excavating a foundation. But I can use the Amex Payment network at the same time as millions of other cardholders.

Social Networks like Facebook, Linkedin and Twitter has powerful network effects working in their favor. Members join these networks because other members are in this network. It is going to take a long time for the competitors to build a network with millions of users from scratch.

Western Union a company which facilitates money transfer is another great example of network effect. Its network is three times larger than its closest competitor. It processes five times more transactions than its competitors. Because of the large number of connections between these locations, customers will have more choices using Western Union.

In the example data given below if all the users are connected you can see the number of connections grows exponentially as the user count increases. How is that possible? Remember Combinations you studied in 8th grade?

Users	Connections
2	1
3	3
4	6
5	10
6	15
7	21
8	28
9	36
10	45
20	190
30	435
40	780
50	1225

eBay is a poster child of network effect. Pat Dorsey once interviewed an analyst for a position at Morningstar

I once asked a candidate applying for an analyst job at Morningstar what he would do If I played venture capitalist, gave him huge amounts of financial backing, and told him to go beat eBay at its own game in the United States. He thought for a minute and then replied “I’d return the money”. Good answer.

4. Cost Advantages

Cost Advantages can come from four sources

1. Cheaper Processes
2. Better locations
3. Unique Assets
4. Greater Scale

4.1 Cheaper Processes

Imagine you own a software consulting company in the United States. All your employees are in the United States. One fine day you wake up with an idea to outsource the work to India. Because of the cheap labor in India you can get the same work done at a very low cost. You got the cost advantage by using a cheaper process. What is the problem with this approach? How much time would it take for your competitor to do the same. Not a lot and this advantage will get eroded very easily.

Southwest airlines is the best example of having cost advantage for a very long time using cheap process. What did it do differently?

1. It locked up the supply of new airplanes which had low maintenance cost.
2. Minimized expensive ground times and flew only one type of jet.
3. Cultivated thrift employee culture.

Why did the existing major airlines did not copy this process? Pat Dorsey writes

In Southwest’s case the incumbent airlines did not copy its low cost process for a number of reasons. First, a rigid union structure meant that pilots weren’t about to start helping clean planes at the incumbents. Second Southwest’s point-to-point route structure would have made it hard for the majors to feed profitable business and international passengers through their expensively maintained hubs. Third, Southwest was an aggressively egalitarian airline – no separate classes, no assigned seats – in an industry that made a lot of money by treating some passengers like royalty and charging them for the privilege. In short, the majors would had to figuratively blow up their businesses to gain Southwest’s cost advantage, and it’s hard to blow up your own business.

In all you need to be very careful if the company just has a process based moat as it can be copied easily by the competitor.

4.2 Better Locations

Location is very hard to duplicate and hence this advantage is much better than the cheap processes.

Posco is a multinational steel making company in South Korea. It controls 75% of the countries steel production. It has to import raw materials for making steel. But the biggest advantage is its location. It can ship steel to China in a day and this means its transportation cost will be very low compared to its competitors. On top of this South Korea itself has a massive automobile and ship building industries to which the company can supply steel at a very low cost. Warren Buffett holds POSCO shares for Berkshire Hathaway. Take a look at the map of where it is located and it will you tell you the story.

4.3 Unique Assets

Aracruz cellulose, a Brazilian company which manufactures pulp and paper. Eucalyptus tree is used for manufacturing pulp and paper. In Brazil, eucalyptus seedlings matures in 7 years compared to 10 years in Chile and 20+ years in North America. This means compared to North America Eucalyptus trees can grow 3 times faster in Brazil. This gives a huge advantage for Aracruz cellulose and hence it is the largest low cost producer of pulp and paper.

4.4 Greater Scale

To understand scale advantage we need to understand the difference between fixed cost and variable cost. Imagine you own a rental real estate property. Its fixed costs are

• Property Tax
• HOA
• Insurance
• Mortgage

Its variable costs are

• Maintenance
• Property Management Fees

Whether the property is rented or not you need to pay the fixed cost. For any business higher the fixed cost relative to variable cost it tends to have scaled based advantages. Why? For the competitor to enter the business it needs to deploy a lot of capital towards fixed costs. Not many will do this.

Scale based advantages can be further categorized into

1. Distribution
2. Manufacturing
3. Niche Markets

4.4.1 Distribution

United Parcel Service (UPS) has a dense ground delivery network. Once UPS covers its fixed costs, the cost of delivering extra packages will result in huge profit margin for the company.  Because of this the company earns higher return on capital compared to its rival Fedex which does a lot of overnight letter services.

In the Elementary Worldly Wisdom – Charlie Munger talks about the distribution advantages of Coca-Cola

Well, suppose you have a little soft drink. Exactly how do you make it available all over the Earth? The worldwide distribution setup—which is slowly won by a big enterprise—gets to be a huge advantage…. And if you think about it, once you get enough advantages of that type, it can become very hard for anybody to dislodge you.

4.4.2 Manufacturing

Electronic Arts is a video game manufacturing company. Pat Dorsey writes

Video game giant Electronic Arts, for example, has an easier time creating fantastic video games than smaller companies because the cost of brining a video game to market – currently around $25 million is essentially fixed, and Electronic Arts can spread the massive development costs of this video games over a larger overall sales base.

4.4.3 Niche Markets

Companies can create near monopolies in markets that are only large enough to support a single company. In the Elementary Worldly Wisdom – Charlie Munger talks about the daily newspapers.

There’s another kind of advantage to scale. In some businesses, the very nature of things is to sort of cascade toward the overwhelming dominance of one firm. The most obvious one is daily newspapers. There’s practically no city left in the U.S., aside from a few very big ones, where there’s more than one daily newspaper. And again, that’s a scale thing. Once I get most of the circulation, I get most of the advertising. And once I get most of the advertising and circulation, why would anyone want the thinner paper with less information in it? So it tends to cascade to a winner take all situation. And that’s a separate form of the advantages of scale phenomenon.

Blackboard develops software for Learning Management Systems. It’s software application connects faculty and students. It controls about two-thirds of the market for Learning Management Systems. Pat Dorsey writes

This market is not very big for players like Microsoft or Adobe to enter. It is also highly specialized market, so a competitor would probably need to expend substantial resources to learn what customers want before being successful – and because the market is relatively small, few companies will try.

Remember this

Being a big fish in a small pond is much better than being a bigger fish in a bigger pond.

Closing Thoughts

Investing successfully is very hard. To increase your odds of success find out companies with moats and buy them when the price is right. Charlie Munger tells that

I think the idea that everyone can have wonderful results from stocks is inherently crazy.  Nobody expects everyone to succeed at poker.

In Elementary Worldly Wisdom Charlie Munger writes

And the one thing that all those winning betters in the whole history of people who’ve beaten the pari-mutuel system have is quite simple. They bet very seldom. It’s not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it—who look and sift the world for a mis priced bet—that they can occasionally find one. And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple. That is a very simple concept. And to me it’s obviously right—based on experience not only from the pari-mutuel system, but everywhere else.