Pat Dorsey explains moats
Note: This post will continue to get updated and will be the anchor post on Moats.
Sectors with high rates of return on capital tend to experience fall in returns as competitors enter the market. But there are a small minority of companies which enjoy many years of high returns. This is by creating structural and sustainable competitive advantages, or economic moats.
Moat manifests itself in pricing power – if the company can’t raise prices at its wish, there may not be a moat. Companies losing pricing power are losing their moat.
There are four categories of moats:
(1) Intangible assets
- Brands – If the brand is able to charge a premium for the product, there is value for the brand (eg: Tiffany). Another way the brand creates value is by lowering search costs for consumers (essentially by way of better brand recall) (eg: Amazon, Coca Cola).
- Brands are valuable if they deliver a consistent or aspirational experience. Consistency lowers search costs and drives loyalty. Aspiration increases willingless to pay, and hence companies should create scarcity and exclusivity.
- Patents – They are valuable if the company has a portfolio of patents. The problem with patents is that they are exposed to expiration and challenges. If the company banks on just a few patents, they might get challenged, and the company will be in trouble. eg: Qualcomm
- Licenses / Approvals – Regulatory approval process is a huge barrier to entry and a big moat.
(2) Switching costs
The question to ask here is – “does the cost of switching to a competing product or service outweigh the benefits?”
- Integrate with customer’s business: The higher the integration, the higher the switching costs, and the higher the pricing power on renewals. eg: SAP or Oracle
- Sell ongoing service relationships: Customers are likely to stick to the company which sold the product / service initially, than change to some other provider.
- Provide a product with a high benefit / cost ratio: If a product increases efficiency or decrease downtime by a meaningful amount, customers will likely prefer that product even if it is more expensive.
(3) Network effect
This is about providing a service that increases in value, as the number of users expands.
Here, interactive networks are more valuable than radial networks. In an interactive network, one node can communicate with any other node – like facebook – and they grow exponentially, and hence hard to beat by a competitor. Radial networks are organised as channels.
(4) Cost advantages
This can be done in three ways:
- Process: Invent a cheaper way to deliver a product that can’t be delivered quickly. This could get copied eventually.
- Scale: This helps to spread fixed costs over a large base. This leads to lower incremental cost of delivering product or service. Scale advantages are quite tough to beat.
- Niche: Some niches can profitably support only two or three players. If new players try to take market share, everyone loses money. In such businesses, competitors may not enter. While the revenues may not have much room to grow, these businesses can be enormously profitable.
Managements – how do they fit in the moat framework?
If the business has a good moat, then even an average manager might be enough. However good the manager be, he can’t save a bad business.
- Good manager constantly try increase moat (eg: Amazon’s focus on customer experience).
- Bad managers invest capital outside a company’s moat (de-worsification) and decrease returns. Companies do this when their core business slowdown, and try to get the company back to higher growth path.
- In ‘moaty’ businesses, managers are like caretakers – to keep it going as it is, and not screw up. In non-moat, commoditised businesses, managers can impact the business in a big way.
Value of moat
- The value of an economic moat is largely dependent on reinvestment opportunities. Some high moat businesses are able to reinvest at a high incremental RoIC.
- Moats may not be priced in. This could be due to various reasons, some of which are – (i) short holding periods of investors, (ii) expectations that current global scenarios will persist longer that it usually does, or (iii) short-term focus on price changes rather than long-term changes in moats.
- Quantitative data is efficiently priced by the market, but qualitative insight is less efficiently priced.
- If you are going to make money mainly by closing the gap between price and intrinsic value, rather than compounding of intrinsic value, then keep higher margin of safety.
- While modelling costs, try to think in terms of fixed vs. variable – basically, operating leverage.
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