Another post in the series of Investment Ideas. Be sure to check out earlier posts on Family Owned Businesses & Great Capital Allocators as a method of screening and finding good investment opportunities.
Most investors have heard Warren Buffett talk about economic moats of businesses. To jog some memory, here’s a quote from Berkshire’s 2000 annual meeting:
“So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes. However, if the moat is widened every year, the business will do very well. When we see a moat that’s tenuous in any way — it’s just too risky. We don’t know how to evaluate that. And, therefore, we leave it alone. We think that all of our businesses — or virtually all of our businesses — have pretty darned good moats.”
While the idea is easy enough to understand, due to the large amount of companies in the investable universe, narrowing down the list of target companies is a bit hard due to time cost. To come to a conclusion on the moat of a business, investors need to dig deep and understand each business well, and come up with qualitative aspects of the business in addition to the quantitative data & the valuation. Lucky for us, there are institutions in the industry that do the legwork and can give us a starting point on wide moat companies.
But before we go there, lets take a quick classification of moat sources. Usually a company’s economic moat is classified as:
- Narrow-moat or
Note that these moats are not constant. Companies routinely have a widening moat or a shrinking moat…so the tricky part is to identify and keep track of whether a moat is growing or eroding year after year.
There are some brilliant resources online that shed more light on moats and instead of repeating everything on this blog, I will link to some of the good resources below. By far the most widely known resource that tracks and discusses economic moats is Morningstar. Morningstar has developed a process which tracks large cap companies and classifies them into the ‘moats’ model. Broadly speaking, economic moats can come from:
- Network Effect: Companies that get stronger due to more customers belonging to the network such as Visa (V), Facebook (FB), CME Group (CME) etc.
- Cost Advantage: Companies like Walmart (WMT), United Parcel Service (UPS) etc who can provide better prices to customers.
- Intangible Assets: High brand value companies such as Coca Cola (KO), Disney (DIS) etc.
- Switching Costs: Where customers find it too hard/expensive to switch away. Companies such as Oracle (ORCL), Salesforce (CRM) etc.
- Efficient Scale: Companies have attained efficiency due to scale, so new companies do not find enough of a reward to enter the marketplace. Companies such as Canadian National Railway (CNR.TO)(CNI), Dominion Energy (D) etc.
A good way to think about it is if someone gave an investor…say $1B for e.g., and was asked to go start a company and disrupt one of the incumbents, can that be done? What is the possibility of achieving that goal? Can a startup really disrupt Diageo plc (DEO) or Union Pacific (UNP) with $X funding?
Resources for More Research
A few investors that are worth listening & following in this space are: (1) Patrick Dorsey from Dorsey Asset Management, previously at Morningstar. I tweeted a few of his videos here; (2) Thomas Russo who focuses on consumer goods and their brand values. Here is a page from ValueWalk with plenty of links to his articles & videos; (3) Paul Black from WCM Investment Management. I tweeted about him earlier this year here. There are other great investors who highlight this model as well, but those three are good starting points.
Other good resources for ideas are ETFs. There are two ETFs that focus on this factor: VanEck Vectors Morningstar Wide Moat ETF (MOAT) for US-based companies and VanEck Vectors Morningstar Global Wide Moat ETF (GOAT) for global exposure.
Do you pay attention to the economic moats in your investment decision? Do you have any other companies that you consider to have a wide economic moat, but often misunderstood? Share your thoughts below.
Further Reading: This Credit Suisse paper from Michael J. Mauboussin titled ‘Measuring the Moat’ is a good read.
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