The term economic moat has become widely familiar in the investing world. It refers to a business’s ability to maintain competitive advantages over its competitors in order to generate excellent returns on invested capital.
The keyword here lies in maintain. An economic moat is not simply a competitive advantage that currently allows a company to earn excess returns over its competitors and cost of capital. It’s one that is expected to last, continuously fending off attacks to the economic castle.
In our previous note about return on invested capital (ROIC), we did a comprehensive walkthrough of how to properly calculate and think about the key economic measure of whether a business creates superior returns.
We looked at such returns on an ex post basis. And consequently, that note ended with the following disheartening conclusion.
Here’s the tragedy of the story: just studying the returns on invested capital a company has generated in the past says little about the incremental returns it will generate in the future. Financial acumen matters little here and forecasting a company’s future excess returns is really a different ball game. But studying the past may grant us clues to the future.
Oh well, we’ll try to get one step closer in future notes.
This is one of those future notes and we will now attempt to shed a little light on some of the clues that might help investors catch a company with an evolving—or growing—economic moat.
Spotting an economic moat as it evolves is not an easy thing to do. But, here are seven signs that might tell an economic moat is emerging.
1. The management displays an excellent understanding of the right company culture.
The first one on the list is self-evident and of intangible quality. Corporate culture is not an isolated thing in terms of an economic moat because a strong corporate culture is a prerequisite behind any successful business. A company’s culture is its operating system.
One of the best mental models for understanding the importance that culture has on a business is the model of reciprocation as described by Robert Cialdini in his book, Influence.
If a company treats its employees well in a thriving environment, those employees reciprocate the treatment by working harder. And if the corporate culture reflects a win-win-win relationship with all day-to-day stakeholders—customers, suppliers, employees—those stakeholders will reciprocate, the company prospers, and the economic moat widens since entities want to work with someone who is reliable. Strong culture fosters reliability.
Thinking inversely: you rarely, if ever, find a company that consistently earns high returns on capital while simultaneously keeping either unhappy employees or dissatisfied customers.
At the 2021 Daily Journal annual meeting, someone asked the question of how important culture was in the investment process to which Charlie Munger answered:
It’s quite important—part of the success of a company like Costco. It’s been amazing that one little company starting up not that many decades ago could become as big as Costco did as fast as Costco did. Part of the reason for that was cultural. They have created a strong culture of fanaticism about cost, quality, efficiency, and honor. All the good things. And, of course, it’s all worked. Culture is very important.
Culture is strongly tied to the leadership of the business. Higher management sets the tone for the organization, and company values and behavior are often derived directly from the personality of either the founder/owner and the management team. Hence, significant time from management must be spent on shaping and reinforcing culture by identifying and promoting cultural barriers.
The clearest way to gain an understanding of a company’s focus on culture is through its 10-K or annual report. More specifically, through the letter to the shareholders and the management discussion and analysis (MD&A).
Does the tone of the report give the impression that the company provides an atmosphere with a sense of belonging and identity for the employees? In a Harvard Business Review paper, the authors concluded that belonging was linked to a whopping 56% increase in job performance, a 50% drop in turnover risk, and a 75% reduction in sick days and that for a 10,000-person company, this would result in annual savings of more than $52M. Starbucks—a great cultural company—has long referred to its employees as “partners”.
Let’s take Charlie Munger’s word and look at the business of Costco relative to Sam’s Club under Walmart. The two businesses look very similar. However, Costco sales per square foot are more than double that of Sam’s Club, revenue per employee is higher, and the employee turnover is exceptionally lower. Costco pays its employees more because its employees are the starting point of customer satisfaction. Costco is a company that exudes an image of reliability because it fanatically puts the employees first.
Another excellent under-the-radar tool to gauge employee happiness is through Glassdoor which is a recruiting site offering valuable insights from the people who know best—the employees and candidates who have been there.
Secondly, does management admit to mistakes? And does management display humility and a willingness to continuously learn from its peers, customers, and employees in an endless pursuit of perfection? If it does, it displays a sense of ownership which is very likely to flow to other areas of the business as well and down the organization.
Finally, does the corporate narrative display a sense of shared goals and values within the firm? As John Mackey, founder and CEO of Whole Foods, once said:
Most of the greatest companies in the world also have great purposes….Having a deeper, more transcendent purpose is highly energizing for all of the various interdependent stakeholders.
2. The price of the product or service increases at a faster rate than inflation while growing volumes and increasing margins.
This one is the easiest to spot as it evolves. You see the company raising its prices, gross margins go up, revenue growth does not slow down, and the operating margins increase as well.
While a price raise in most businesses results in a loss of demand, a price increase in a business with pricing power only minimally impacts demand—or not at all.
A business like that is likely either operating a local monopoly, owns proprietary patents, or is immensely growing its brand as a form of necessity. When you’re the only game in town, you can price that game at a hefty premium. Autohome’s dealer subscription business is a good example of being a necessary good with significant pricing power. Auto dealers can’t possibly compete against local competitors if these competitors market their businesses on Autohome and they themselves do not.
Both good examples and bad examples abound in these types of businesses. Disney and Apple can keep raising prices due to unique experiences and strong brand equity, while another company by the name of Valeant Pharmaceuticals (now Bausch Health Companies) based its entire business model on acquiring drugs with little to no competition and hiking prices to the highest price that the medical market would bear. The prior keep providing the same or better value to its customers while the latter exploited its dominant position of people’s well-being which ultimately led to its own collapse.
3. The company has a sales channel and incentive structure that allows effective distribution.
A unique distribution channel can come in handy to build a competitive advantage when working with a rather undifferentiated product or service (such as financial services). This essentially works to become the lowest-cost competitor. And sometimes, when all the right things fall into place, such a model is not easily copyable by competitors and can turn into a long-lasting moat.
An effective distribution channel works best if channel conflicts disallow competitors from copying the method. An obvious example here is Google’s wide moat in search. The network effects that arrived with Google being the only default choice in internet search has in effect blocked the channel to be utilized by competitors. Television networks and the legacy local monopoly newspaper businesses are previous examples of deep moats originating from the same nature (but which dissolved quickly from disruption).
A channel conflict can also arise from the costs and time it would take a competitor to build out the distribution network. A start-up today could never replicate Coca-Cola’s distribution network.
If the company owns a distribution channel that other businesses rely on and has the scale, bargaining power can turn very lucrative. Large retail chains have a significant bargaining power relative to small CPG businesses looking to utilize existing channels. Walmart is an example of a business capturing a lot of value from this position.
4. The company shows increasing working capital efficiency.
Being the topic that most often confuses people, working capital is not a direct source of an economic moat. But a company’s economic moat can show up in its working capital.
Working capital is often misunderstood for cash—which it is not. In this case—as should be the default case in valuation purposes—cash (and investments in marketable securities) is in fact taken out of the equation. Thus, when thinking about working capital efficiency, you should just think of the operating (or non-cash) working capital.
While largely dependent on the nature of the business and its industry, a company that operates with a negative working capital can use supplier credit to grow. Dell has used this strategy with success.
An increasing working capital efficiency can mean a bunch of things. A faster inventory turnover might show up, indicating either rising demand and/or improved operations. Increasing accounts payables might indicate better bargaining for credit extension. Either way, working capital efficiency is a good place to look for an early growing economic moat.
5. The company ends its high CapEx period.
When a company operating in a capital-necessary business stops investing heavily in capital expenditures, its free cash flows go up immensely. Now, this is obviously not a source of competitive advantage in itself, but it can give you a clue as to what goes on.
It might signal that the company heavily investing in utilizing technology in its business processes—like moving to the cloud. Or, it might signal that the business has found a smarter of doing business, requiring little capital—like retail businesses building a wide franchising network.
6. Well-capitalized competitors give up competing or formulate a strategy that implicitly acknowledges they cannot compete.
It’s difficult to truly acknowledge the existence of a moat until it is attacked and the attack is repelled. When Apple launched Apple Pay, they did so on Mastercard’s and Visa’s rails rather than trying to end-run. And they did so despite having almost unlimited resources as well as direct customer relationships to launch upon.
7. The business mix shifts to higher-margin segments.
Vertical software businesses such as Constellation Software or Netcompany generate revenue from maintaining their clients’ enterprise software, indicating that clients stick to their solutions. In the case of Constellation Software, the maintenance segment to public and private clients constitute a lucrative high-margin business.
When the business mix slowly tilts to a high margin, low investment segment on the basis of a company’s existing and growing client base, it’s often a clear sign of a growing economic moat as the company’s offering becomes stickier.
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We will end this note by stating that the presence of a moat is not enough. When discovering an economic moat, the thing investors must look for to affirm its durability is whether management does enough to widen the moat every year.
As Warren Buffett eloquently put it at Berkshire Hathaway’s annual general meeting in 2000:
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.
Today, the world has gotten smarter. If you are looking for high-quality, wide-moat businesses selling cheaply—along with a huge number of other market participants—today you are going to find yourself in lots of value traps.
Your focus must not only be on the prevalence and width of an economic moat, but also on the direction of the competitive advantage. Business is dynamic. And every day, any business is either getting stronger or weaker versus their competitors.
You want to be able to make the case with high conviction through pattern recognition that the company in question has a strong likelihood of growing its economic moat over the next ten and fifteen years.
There is both beauty and tragedy to it. The beauty is that if you get the aforementioned part right, any valuation work you do on the company will plausibly look cheap ten years out. The tragedy is that the crocodiles in a moat might be strong and defensible, but like species in biology, virtually no business lasts forever.
To really surf a compounder, you must attempt to catch the wave earlier rather than later. And you must catch on to the wave that everlastingly works against the entropic force of business and biology.
This note gave you seven signs to start off from.
