Wonderful Company Series — Moats
"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price." – Warren Buffett
If we agree with Buffett's above wisdom (often a best practice!), then the question naturally emerges – what constitutes a wonderful company? Our Wonderful Company blog series will outline North Beach Holdings' definition of a wonderful company and provide insight into our public company qualitative research process.
In our opinion, wonderful companies have one or more of the following moat attributes:
Intangible assets
Switching costs
Network effects
Cost advantages
Efficient scale
What is a Moat?
When Buffett coined the term 'moat' in the 90s, he drew the analogy that a business is a medieval castle with the competitive advantages of the company being the moat around the castle – a barrier that keeps it safe from enemies, i.e., competition. Beyond inspiration from Buffett, Pat Dorsey heavily influenced our thought process around moats. Dorsey was Director of Equity Research at Morningstar from 2000 to 2011. He was instrumental in developing Morningstar's framework to analyze competitive advantages and quantify a company's competitive position with an economic moat rating.
So, what is a moat? In summary - a moat is a sustainable advantage that protects a company from the competition and adds value by providing greater certainty of future cash flows while maintaining return on invested capital.
What follows is a broad classification system of business model moats.
Intangible Assets
Intangible assets are brands, patents, or regulatory licenses that lead to mini-monopolies or dominant market positions.
Many individuals make the intellectual mistake of automatically assuming a popular brand provides a competitive advantage. Although having a famous brand with a strong reputation certainly is not a negative, a brand is considered an intangible asset competitive advantage if the company can charge a premium for its products or services versus the competition. I was reminded of a conversation I had in college where a fellow student suggested an investment in Coca-Cola Co over PepsiCo because "Coke seems to advertise more, and Coke tastes better than Pepsi, too." That student had made the mistake of assuming that it must have an advantage over the competition because a brand is popular. In reality, Coke and Pepsi beverages are priced about the same – there is no premium price for one brand versus the other.
A qualitative way to identify a potential brand-based moat is to look at gross margins versus competitors. If a company is selling essentially the same product but has higher gross margins, that could indicate that consumers are willing to pay a higher price.
The ownership of a unique patent can be an intangible asset that provides a competitive advantage. If a company is the only provider of a product and said product is in demand, it can raise prices. Perhaps the best example of this is pharmaceutical companies where a unique drug will be developed and patented and sold for a premium. Then, once the patent expires, generic drug companies begin production, and prices drop. However, relying on a single patent for a sustainable competitive advantage is not a wise idea. After all, there is an entire legal industry centered around challenging patents, and if the courts rule against the company, then its competitive advantage is eradicated instantly. A company that truly benefits from a patent-based intangible asset moat has multiple unique patents, as well as a history of continually developing more.
Being granted regulatory licenses by government entities can be a powerful intangible asset. However, this only applies if, although there is government approval to operate, there is no government oversight on prices. Therefore, utility companies would not benefit from this competitive advantage – they only have the first half of the equation. Being granted numerous licenses by governing bodies at the municipal level is a more robust competitive advantage than one license granted by the state or federal government. Waste Management, a trash collection company, is a great example. The company is granted permission to serve numerous communities, all at the municipal level. Waste Management can price like a monopoly, and if one municipality revokes its license to operate, it will likely not drastically impact the business.
Switching Costs
In my previous blog I touched on wonderful companies having high customer product or service integration. If a company's product or service is a critical component of its customers' business process, they are less likely to switch. This is a component of the switching cost competitive advantage. Switching costs can be monetary or non-monetary, but if the switching costs are high enough, a company can charge higher prices and retain customers.
Monetary switching costs are somewhat obvious. There can be fees for canceling accounts and services, setup charges with a new provider, etc. What is sometimes also obvious but relatively more significant switching costs are non-monetary switching costs. It is even better when these non-monetary costs move beyond product or service integration and into the business and industry culture's very fundamentals.
Two examples of this within the finance industry: Microsoft Excel and the Bloomberg Terminal. There is a strong argument to be made that Excel is the backbone of the entire finance industry. Many businesses rely on it for their various functions, and all incoming young professionals are expected to have training on the software. Are there substitutes for Excel? Sure. But very few would be willing to take the time to retrain their entire staff and transfer all the current Excel spreadsheets over to the new software. A somewhat weaker example is the Bloomberg Terminal. Many financial institutions rely on Bloomberg to source news and financial data, and the service also has a powerful Excel add-in that can auto-populate spreadsheets. There are high-quality substitutes to a Bloomberg Terminal (FactSet, Morningstar, Sentieo), but Bloomberg charges much higher prices than the competition. They can do this because the non-monetary switching costs of retraining and updating spreadsheets is greater than the monetary savings.
Network Effects
If the value of a company's products or services increases with the number of users, that company benefits from a network effect. This competitive advantage is often found in businesses based on information and knowledge transfer rather than businesses based on the manufacturing and sale of physical products. The network effect can be described with a flywheel analogy.
A real example of this can be seen with Points International (PCOM). This Canadian e-commerce company enables the sale and transfer of loyalty currency for some of the world's most extensive loyalty programs. One service Points offers is the ability for customers of partner companies to transfer one loyalty program's currency into the currency of another. If the customer of an airline's loyalty program wants to spend their points on a hotel room, then Points facilitates that exchange. Points' services add value to both the end consumer and its partner companies. Once outside companies with a loyalty program recognize this value, they may decide to partner with Points, as demonstrated by the company's impressive track record of adding and expanding partnerships on an annual basis. After these companies join the Points network, they are now connected to more businesses with loyalty currencies, and as a result, more end consumers. The network effect creates a wide moat for Points International, as it would be nearly impossible for a new entrant to replicate the partnerships that Points has. It would be costly for companies offering independent loyalty currencies to match the same level of service offerings.
Cost Advantages
Cheaper processes, better locations, unique assets, and greater scale can all be the source of a cost advantage.
A competitive advantage based on having cheaper processes than the competition may provide a company with higher gross profits than competitors. Likewise, the same can be said for the opportunity to carve out a more significant share of the total addressable market by offering its product or service at a lower cost than competitors. Although this type of competitive advantage can prove useful in the short-term, these are often unsustainable over the long run, as competition will adopt a similar process that led to the cost advantage.
A great example of this is Toyota Motor Corporation and its creation of Toyota's Production Systems. This system of lean manufacturing allowed Toyota to cut out waste, and as a result, Toyota was more efficient than American car companies. Eventually, General Motors saw the need to implement some of these processes and partnered with Toyota in the 1980s. In the decades since, other American automakers have followed suit and implemented lean manufacturing.
Having better locations than the competition is a more sustainable cost advantage than cheaper processes. If a company is closer to customers than a competitor, then there could be a cost advantage-based moat. For example, a Cleveland based building supply company selling lumber to contractors in Northeast Ohio could have a competitive advantage in that market over a Cincinnati based company. The Cleveland company could offer the same products but at a lower shipping cost.
Access to a unique asset can also provide cost advantages. One example could be a natural gas company having exclusive access to a pipeline allowing the company to provide natural gas in a specific geological area at a lower price than the competition. Suppose a manufacturer has access to an abundance of a natural resource that is a raw material in its products. In that case, it will have a cost advantage over companies that do not have the same access.
Efficient Scale
Following on those cost advantages is perhaps the ultimate cost advantage – efficient scale.
It is crucial to make the distinction between scale and size. Size relative to competitors is more important than absolute size. Just because a company is large does not mean it has an efficient scale. If an industry has high fixed costs relative to variable costs, it is likely more consolidated due to the large initial capital requirements to start a business. Efficient scale is how companies in these industries spread the fixed costs and make incremental profits per unit. Essentially, as output increases, the overall cost per unit decreases. Scale can come from a distribution network, manufacturing capabilities, or operation in a niche market.
Distribution scale advantages can come from route density. A perfect example would be a delivery service. Each route planned for the driver has a fixed cost (fuel, driver pay, etc.). The company must ensure that the scheduled route has enough stops to cover the fixed costs of the route. However, all the stops beyond those that cover the fixed costs provide profits for the company. The fixed cost per stop decreases throughout a dense route, and therefore the profits per stop increase. Output increases, and the overall cost per unit decreases.
When considering a company's scalability or product, it is important to consider how easy it is to roll the product out to a new customer or expand into new areas. Due to the SaaS and recurring revenue business models rise, many companies in the market now have products that can easily be implemented into their customer's business processes. Although this form of scale is different from the traditional manufacturing-based scale, the concept is the same. The fixed costs of developing the SaaS are R&D, and the variable costs are primarily SG&A. Adding more clients or subscribers spreads the R&D cost. The output is increased, and the R&D per client is decreased.
For us, a publicly-traded company must have a moat to be investable. We prefer this moat to be as wide as possible. That width comes from a single, very strong competitive advantage or a mixture of two or more. The goal is to buy wonderful companies at wonderful prices, and wonderful companies must have wonderful moats.
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