Of Castles & Moats – Assessing the Size and Durability of Value Creation

Castles & Wide-Moats.jpg

A wide-moat business ‘castle’

  • delivers a product or service that is needed or highly desired by customers.
  • is thought by its customers to have no close substitute.
  • is not subject to price regulation.

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 being the low-cost customer (GEICO, Costco) or possessing a powerful worldwide 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. A moat that must be continuously rebuilt will eventually be no moat at all – Warren Buffett

  • A high ROIC is a good indicator of the presence of an economic moat. One is not a substitute for the other, and is often accompanied by the other. And yet, having either or both is not sufficient. Endurance in each case is a pre-requisite and in neither case can endurance be fleeting. The business “castle” should not only have them today (or in its past) but be able to keep them that way in the foreseeable future. There must exist a long runway ahead!
  • A “wide-moat” horse not only leads the race, but he is impossible for the competitors to catch up with. A wide-moat horse is so far out ahead, that others abandon all attempts to compete with him. More so, wide-moats can be either “Static” or “Dynamic”. With a “dynamic wide-moat” horse, the gap between him and the other horses is not only wide today but continues to further widen over time. Such a moat then is not merely a defensive structure. It is a dynamic process of scaling which widens the competitive advantage even while growing the business. This leads to the “winner take- most” or “winner-take-all” situations. Incumbent competitors abandon the race while potential upstarts dare not attempt. A volume-price-volume virtuous cycle is an example of a dynamic moat. A customer captivity moat would be considered a static moat.
  • Wide-moat Business-es display the Helium effect – they defy ‘economic gravity’ (free-market competition). They have elements that reinforce the business’ ability to out-earn its cost of capital for extended periods.

Characteristics of Economic Moats – how, how much & how much longer?!

We look at moats from four dimensions:

1. Type or Nature – A business castle could have at least four sources of economic moats. We wish to determine if the castle possesses one or more of these. Multi-moats are (of course) better than uni-moats. Once their presence is detected, their source(s) and their nature demand a clear identification. On encountering a high ROIC, we ought to ask: What aspects of the business causes this to exist?

2. Castle’s beauty

a) What is the business’ Earnings Dynamic? What are the ROIC, ROE, ROA figures?

b) Two beauty tips:

  • Does the ROIC significantly (and not marginally) exceed the “Cost of Capital” (WACC). This is the EVA.
  • How does the ROIC compare with industry peers?

c) What is the Growth dynamic? The ability of the business to absorb re-investment capital to generate earnings growth while maintaining or increasing its high ROIC?

d) What is the Reinvestment dynamic? How much capital is needed to be reinvested to produce the increased earnings growth? Compute the reinvestment rate: GrowthRate/ROIC.

e) How much (outside) capital is required for the “growth” and the “reinvestment” dynamics? Low is good and High is a no-moat.

3. Moat Width

  • How difficult or easy is it for competitors to cross the moat? to copy or replicate the business model?
  • How easy is it in terms of skill, capital, time, or other resources?
  • Is it worth the time and effort of its enemies to attempt breaking into the castle?

4. Moat Durability

  • Past: How long has the moat(s) existed? Is there sufficient past evidence (and not just recent) to justify its existence? How has it been maintained?
  • Future: More importantly…

– Is there evidence that it will remain so or strengthen over time? If so, for how much longer?

– Will the width expand at an increasing rate even as the castle’s beauty (a high ROIC) endures or enhances?

– Is there enough room and buffer in its beauty so that even if it wears out due to the inevitable attacks from marauders, it will remain attractive enough for the owner to keep defending it? Is ROIC-WACC spread or the EVA sufficiently high?

Check not only the rate of growth in any one year, but the number of years it can grow at any rate. A recent wide-moat (a fad) OR a fast-shrinking wide moat OR a moat that has to be continually repaired does NOT qualify as one. A random fashion retailer that happens to get lucky, hit some fashion trend and has a 50% ROIC for a year or two, is not automatically called, “Well, gee, that’s a wide-moat firm. They have a huge ROIC”. Not so fast. They may have just gotten lucky. In contrast, a railroad or a pipeline, may not have very high ROIC. They are actually quite low, around 10%. But the sustainability of that return is exceptionally long and it may qualify as a wide-moat candidate.

Further Observations:

  • The width and the durability of a moat are more important than the castle’s beauty. The best moats defend beautiful castles, are wide, are durable and keep widening over time.
  • A patient visiting a doctor may feel fine, but high cholesterol could make it necessary to act now to prevent heart disease. A company may show strong growth and ROIC, but qualitative health metrics are needed to determine if that performance is sustainable.
  • Often, it may not be attractive for competitors to attack the castle even if they could. Consider a beautiful castle which is just sufficient to hold one occupant. The attacker may find the size uninteresting for his taste and needs. Even, if he does succeed in penetrating it, it could lead to both occupants being miserable. He would ask himself: “Why bother?” and depart. Such a deterrent is itself a moat. (read “ Efficient Scale” in “Sources of Economic Moats” later).
  • Management which is skilled in capital allocation can help preserve moats. Poor cap-allocators, on the other hand, have often succeeded in destroying a wide-moat business. Check management’s track record for a superior/inferior capital allocation.
  • Wide-moats may narrow over time as competitors encroach and fill it. Interestingly the invert occurs too! Narrow-moats in the past may widen. (think BSNF and loading car technology changes).
  • Network-effect moats are least stable. Cost-advantage and Intangible-Asset moats are more durable.

Testing for fitness: A business’ past, its historical growth and ROIC can be measured directly. But its future, the potential for future growth and returns can only be inferred.

Here’s a thought: If your competitors know your secret and still can’t copy it, you’ve got a structural advantage. That’s a wide-moat!


Sources of Economic Moats

A. Intangible Assets

Intangible assets can be unique to companies and deliver fantastic pricing power. They include Brands, Patents, and Regulatory Approvals. (note: watch out for qualifiers in each case)

  • Brands – “we are trusted to do the job and you are not”. Brands are dime a dozen. Popular brands aren’t always profitable brands. Brands do not confer a moat in and of themselves. They can only add value if they can increase a customer’s willingness to pay a premium or increase customer captivity leading to repeat business or if they reduce the cost to provide a product. Not all brands carry the ability to price at a premium. While Coca-Cola may be able to charge a fortune for sugared water, French Connection can’t charge a premium for its bargain bucket fashions. If a brand cannot entice consumers to pay more, then it’s not, repeat not, a wide-moat business. bottom line: look for customer captivity AND pricing power.
  • Patents – “even if you wanted to, you legally cannot do what we do”. These are wonderful to have. They allow companies to generate excess profits while rivals are legally barred from competing. Think Apple. Think Viagra while it lasted (sic). Effective patents of great products are a license to print money as they provide monopoly conditions. But, it must have a demonstrated record of innovation that can continue, as well as a wide variety of patented products. Also remember that patent lawyers are not poor, and litigation can be rife… so be careful. Patents expire, so watch out for single patent companies. Legal challenges are the biggest risk to a patent moat.
  • Regulatory Approvals – These can lead to sustainable competitive advantages if the rules make it difficult or even impossible for competitors to enter the market. Regulations are especially favourable if a company can operate like a monopoly but isn’t regulated like one with regard to pricing. Excellent returns can be found in such eclectic businesses as waste disposal sites, credit rating agencies or financial services firms. Look for big barriers to entry due to high regulatory hurdles which can lead to pricing power. Regulations can limit competition—it’s great when the government does something nice for you! The best kind of regulatory moat is one created by a number of small-scale rules, rather than one big rule that could be changed.

The key in assessing intangible assets is thinking about how much value they can create for a company, and how long they are likely to last. Think 2-D: Quantitative (ROIC, Castle-Beauty) and Qualitative (source of the moat and its durability). If you can find a brand that gives pricing power or a regulatory approval that limits competition, or a company with a diversified set of patents and a solid history of innovation, odds are good you’ve found a company with a moat.

B. Switching Costs

Switching costs are the expenses—in time or money—that a customer would incur to change from one producer or provider to another. Customers facing high switching costs often won’t switch even if a competitor is offering a lower price or a better-performing product or service. The improvement in performance or price must be large enough to offset the cost of switching. High switching costs are especially prevalent and powerful when there is a high cost of failure or the cost of the specific product or service is low relative to the customer’s total operating costs.

Companies that make it tough for customers to use a competitors’ product or service create switching costs. The customer can then be charged more, which helps maintain high ROICs. Switching costs come in many flavors—tight integration with a customer’s business, monetary costs, retraining costs, to name just a few. At times even when the customer can switch, the benefits of switching are so uncertain that people take the path of least resistance (status quo bias). Banks historically have been able to charge nosebleed fees to their customers because people just can’t be bothered with the hassle of switching banks. Similarly, costs of switching are high for companies or individuals that rely on integrated software – data processing, securities custodians, tax or accounting can be great businesses (e.g. Sage (LON:SGE), Intuit)

C. Network Effects

A form of switching costs that is so powerful it deserves its own category. Its rare. A company benefits from this effect when the value of its products or services increases with the number of users, both new and existing. The network effect is a virtuous cycle that allows strong companies to get even stronger. Think Credit Cards, online auctions, financial exchanges,..etc. It’s mostly found in businesses sharing information or connecting users(“non-rival goods”). Think eBay and the fact that no other auction site can compete, or Facebook in the social graph. Or Visa and Amex with millions of pay points benefit from massive network effects as does Microsoft with a virtual monopoly in office software due to the fact that everyone needs to open .doc and .xls files. Watch out though – network effects can break down! Witness falling margins in stock exchanges as new competition enters. So look for closed networks and ask: How might the network open up to other participants?

D. Cost Advantages

Companies can dig economic moats around their businesses by having sustainably lower costs than their competitors. Cost advantages matter most where price is a big part of the customer’s purchase decision. Even if a cost advantage exists, think whether a product or service has an easily available substitute. If so, then the cost advantage could either be small or temporary – witness the poor economics in Airlines, Autos or Microchips. But cost advantages can be sustained for a long time in certain situations. There are four sources of cost advantages:

  1. Cheaper or a Unique process,
  2. Superior location,
  3. Access to unique asset or resource(s),
  4. Scale.
  • Cheaper or Unique Process – “we move our stuff faster, cheaper and more reliably than you”. Process advantages are interesting. But they can act as a moat only if they can’t or won’t be easily replicated by competitors. While some companies (think Dell or Southwest Airlines) have been able to carve out unseemly profits due to a better process, be warned! they are not as enduring as other moats. A company like ASOS (LON:ASC) may be winning with web-savvy marketing at present, but it may not last! Keep a close eye on process-based advantages. What one company can invent, another can copy.
  • Location, Location, Location – “we have our stuff in the right places and you don’t”. An advantageous location can give a company a cost edge, and this leg up can be sustainable, given the difficulty of duplication. Think quarries, waste haulage and local steel mills. Heavy, cheap products are best in local networks as competitors can’t ship in products to compete economically – gravel can be a better business than liquid natural gas due to the low value to weight ratio. eg. Union Pacific RailRoad. NOTE: it still has to compete with trucks.
  • Unique Asset – Access to a unique asset can’t be easily replicated by competitors. If you can own commodity assets with lower extraction costs than any other competitor then obviously you’ll have a great moat.
  • Economies of Scale‘we are so big, not using us is going to cost you’

Scale is the king of cost advantages. Companies that enjoy economies of scale have lower average costs than their competitors with smaller capacities..

  1. Being a big fish in a small pond is much better than being a bigger fish in a bigger pond. Focus on the fish-to-pond ratio, not the absolute size of the fish.
  2. Delivering fish more cheaply than anyone else can be pretty profitable. So can delivering other stuff.
  3. Scale economies have nothing to do with the skin on a fish, but they can create durable competitive advantages.

Scale advantage is further broken down into distribution networks, manufacturing scale and niche markets.

1. Distribution Networks – Industries with higher fixed costs relative to variable costs tend to be more consolidated – think Fedex vs Estate Agents. Any guy with a phone can be an estate agent but you can’t easily compete with a national parcel distribution network! Half full vans cover fixed costs so additional parcels go straight to bottom line, difficult to compete with.

2. Manufacturing Scale – Massive upstream oil refining scale at Exxon Mobil is an example. But it’s also evident in massive sales distribution networks – for example in marketing video games. Electronic Arts can spread the cost of developing a game over a massive sales network. British Sky Broadcasting (LON:BSY) in the UK can dominate its rivals with massive subscriber network and the satellite dish switching cost.

3. Niche Markets – Small niche markets, like local cable networks, or school software can also be incredibly profitable niches.

  • Efficient scale
    This is a dynamic in which a market of limited size is effectively served by one company or a small handful of companies. The incumbents generate economic profits, but a potential competitor is discouraged from entering because doing so would cause returns in the market to fall well below the cost of capital. This phenomenon especially makes sense when a new entrant would have to sink a lot of capital. To cover its entry costs, it would want a sufficient share of the market, but if the market opportunity is limited, a fight for share would cause prices to fall and would hurt returns for all players in the industry.

Searching for Moats

  1. It’s easier to create a competitive advantage in some industries than it is in others. Life is not fair.
  2. Moats are absolute, not relative. The fourth-best company in a structurally attractive industry may very well have a wider moat than the best company in a brutally competitive industry.
  3. High FCF margin >7% is worth looking into.
  4. High ROIC, ROE > 12% or higher on a long-term basis may indicate a company with pricing power or cost advantages. In case of ROE, watch out for leverage.

As investors, we’re not stuck trying to make lemons into lemonade, as are the executives trying to shepherd companies through brutally competitive industries. Instead, we can survey the entire investment landscape, look for the companies that demonstrate signs of economic moats, and focus our attention on those promising candidates. If some industries are more structurally attractive than others, we can spend more time investigating them, because our odds of finding companies with economic moats are higher. We can even write off entire swaths of the market if we don’t think they have attractive competitive characteristics.

False Moats

Caution 1: Beware of companies that promote their great management, great execution, great products and big market share. These attributes do not bring a sustainable advantage on their own. The history of business is littered with the wrecks of companies with false moats – RBS (Fred the Shred), Palm Pilots (Product), Kodak/Blackberry (Market Share)……to name a few.

Caution 2: Steer clear of industries with bad economics. Wide economic moats are found in industries like Media, Healthcare, Business Services, Asset Management, Consumer Goods and Software than in industries with occasionally brutally awful economics like Airlines, Telecommunications, Steel & Aluminum, Paper and Forest Products, …(the list is not short). Having noted this, we find often that even the best industries include value- destroying companies, while the worst industries have value-creating companies. (poor horses found in good breeds, good horses found in poor breeds). That some companies buck the economics of their industry should provide insight into the source of their economic performance. And if severely mispriced by the market, they may represent excellent value-investing opportunities. But beware the “contrast bias” as also the “outcome bias”. So judge results only in light of the process. And watch out for the “base-rate fallacy”.

Caution 3: Be careful on crediting management

  1. Bet on the horse, not the jockey. Management matters, but far less than moats. Beware the illusion of skill bias.
  2. Investing is all about odds, and a wide-moat company managed by an average CEO will give you better odds of long-run success than a no-moat company managed by a superstar.

Erosion of Moats

  1. Technological change can destroy competitive advantages, but this is a bigger worry for companies that are enabled by technology than it is for companies that sell technology because the effects can be more unexpected. think buggy whips or Eastman Kodak.
  2. If a company’s customer base becomes more concentrated, or if a competitor has goals other than making money, the moat may be in danger.
  3. Growth is not always good. It’s better for a company to make lots of money doing what it is good at, and give the excess back to shareholder than it is to throw the excess profits at a questionable line of business with no moat. Microsoft could get away with it, but most companies can’t.

Notes from Pat Dorsey’s The Little Book That Builds Wealth

  1. Moats are structural characteristics inherent to a business.
  2. The cold hard truth is that some businesses are simply better than others.
  3. Great products, great size, great execution, and great management do not (I repeat: do not) necessarily create long-term competitive advantages. They’re nice to have, but they’re not enough. Watch out for the mistaken belief that they are.
  4. The four sources of structural competitive advantage are Intangible Assets, Switching costs, Network effect, and Cost advantages. Economies of Scale is the king of cost advantages.
  5. If you find a company with solid returns on capital and one or more moat characteristics, you have likely but not necessarily found a wide-moat business.

Does it exist?

  1. To see if a company has an economic moat, first check its historical track record of generating returns on capital. Strong returns indicate that the company may have a moat, while poor returns point to a definite lack of a competitive advantage—unless the company’s business has changed substantially which is possible but usually unlikely.
  2. If historical ROICs are strong, ask: what is creating it? and how will the company maintain them? Identify the moat. If you can’t answer why the ROIC will stay strong, the company likely does not have a moat.
  3. If you can identify a moat, think about how strong it is and how long it will last. Some moats last for decades, while others are less durable.
Husain Kothari
17 April 2014

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