Understanding Moats : The Little Book that builds Wealth

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Couple of months back I saw one of the talks by Pat Dorsey in Talks at Google. Where he talks about Competitive advantages of companies, which is the key for shareholder wealth maximization.  Being a student of Charlie Munger, I have always been fascinated by the concept of Moats and Floats. So his talk really grabbed by attention and made me read his book Little Book that Builds Wealth, where he talks about the concept of economic moats and how to identify them. Identifying the moat is a key for us in investing, which was made popular by Warren Buffet.  In this book he gives a simple framework on how to indentify the moats, and in most cases what have been the source of this sustainable competitive advantages.

Not every industry and every business can have a sustained competitive advantage or moats.

Reminds me of my finance professor who said – Life is not Fair. Airline industry is the best example for this. I would take the Indian Airline industry as a good example, we have repeated cases now – Kingfisher, Jet Airways, Sahara and now the latest Spice Jet Fiasco. None of these companies helped with share holder value maximization but I did enjoy some good trips in each of these airlines. I also do not have any loyalty when I fly and focus only on cost and who is ready to give me low cost. An Economic moats provide the company an undue advantage to generate more than reasonable profits by way of pricing power over customers.  What contributes to these economic moats for these companies, can be broadly put, as per Dorsey, into these 4 categories.

  1. Intangibles Assets: These could be a Brand (Eg: Audi, McDonalds, Coke, etc.)  Patents (Pharma companies play this game) or Licenses / Regulatory approvals to operate in a regulated industry where there is no regulation on pricing power (Eg.: Moodys). In all these cases, Intangible assets become a moat if a brand could help the company charge a premium price, or a company has a history of filing Patents and coming up with innovations or price like a monopoly with a set of regulatory approvals.
  2. Customer Switching Costs : This would be an economic moat if the cost of switching outweigh benefits or there is a tight integration with the business.  Banks are the best example for this. I have not moved away from my ICICI account, since the time I opened my Savings account back in 2006 because of the integration it has with so many other transactions in my life. Even Once I had tried moving to Kotak Bank, but I just could not change. So once the customer is locked, they do not want to change the product, and ok to forgo a little additional cost to overcome this pain of switching. Enterprise software companies like Adobe, Microsoft etc. and  Asset & Tax management companies Vanguard, Intuit. are best example. Event if there is a significant retraining cost involved customer would stick to the same product, and that serves a moat.
  3. Network Effect :  This is my favorite and fascinating form of moat which can exist only on non-rival goods. A non-rival goods may be consumed by one consumer without preventing simultaneous consumption by others. This mostly exist in information technology industry. Some example are Microsoft, Ebay, Visa , Facebook etc. Facebook for example has more users because already more users are there. Once it has gained a critical mass it builds because of the existing mass. Microsoft office is used by many , because lots of others are already using office. Ebay – more  sellers bring more buyers, and more buyers bring more sellers. Lets take the case of App development in a platform like Windows, Android or iOS. More Apps gets more users to the platform, and more users make the developers build more Apps. There is a virtuous cycle existing here leading to a positive feedback and that serves as a strong economic moat for the company to price the product strongly and fend competition to enter into their space.
  4. Cost & Size Advantages : Companies that are able to manage low cost because of the unique asset they own (like a mine), or process or manufacturing technology that is an advantage over competitors to generate a higher profit margin. Process based cost advantage are tough to survive over longer tenure like the Southwest or Dell example. But the location (where proximity to need and cost of transportation of the product is key) and unique asset based cost advantage can sustain longer. Similar cost advantage could come from the economies of scale, where the bigger volumes can pull down the cost and often tough for new competitors to get to the scale that existing companies operate. It would need large capital and time to replicate which could serve as economic moats.

When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.  - Warren Buffet

So to identify the best bets to invest as a long term  shareholder it is important to invest based on the underlying business and what is the economic moat it has. The 3 steps that is called out are - look for the demonstrated profitable history of the company, and identify the reason for their sustained profitability over years also discounting for risks associated with their moats eroding or profits shrinking and finally value that firm based on their intrinsic valuation like a DCF or by relative price multiple valuation (P/S, P/BV  or P/E).  When we read things look easy, only when we actually dirty our hands by doing , things get hard.  A quick and crisp read if you are interested in understanding competitive advantages and how to understand these moats.

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