What is an economic moat and how can this help an investment portfolio?

Finance & Fury Podcast

Welcome to Finance and Fury. In this episode, we will be looking at investing using a moat.

1. Moats are an effective tool for defence historically – you would put one up around a fortified structures – such as a castle or town – can be filled with water or not, many different types and variations – but the whole aim is to make a location more defensive from attacks – so what does a moat have to do with investing?
   1. Well – in this episode we aren’t talking about defending your castle from some medieval invaders – we are talking about moats that can be identified to provide some defence for your investments – in particular – we will focus on Economic Moats -

What is an economic moat?

2. An economic moat – simply put – is the ability of a business to maintain a competitive advantages over its competitors
   1. This – like a moat around a castle - helps a company to protect its long-term profits and market share from competing firms – which in this analogy would be the attackers
3. a competitive advantage is essentially any factor that allows a company to produce goods or services better, or more cheaply than its competitors – this means that this company is likely to outperform its competitors due to capturing a larger market share and therefore, generating better profits
   1. Castles also had competitive advantages – you could place one on top of a hill – or have a drawbridge across a moat – making it harder to breach the gates – no two castles were exactly the same, as the landscape and designs of the time all vary from location to location
   2. This is the same when looking at shares in a company - When talking about companies – a competitive advantage is evident if the company has been able to maintain a market share due to a combination of different competitive advantages – essentially putting it in a monopolistic or oligopolistic environment

Different types of economic moats – There are several ways in which a company creates an economic moat that allows it to have a significant advantage over its competitors – we will go through 6 types – But by no means are these all-inclusive -

1. Cost Advantage - a cost advantage that competitors cannot replicate can be a very effective economic moat.
   1. Companies with significant cost advantages can undercut the prices of any competitor that attempts to move into their industry, either forcing the competitor to leave the industry or at least impeding its growth. Companies with sustainable cost advantages can maintain a very large market share of their industry by squeezing out any new competitors who try to move in.
      1. Successful Resource companies often have a cost advantage over their competitors – when you look at this industry – the price of the materials can vary – but if you have the lowest costs – you can weather the storm
      2. BHP – has a cost base of just under $12 per tonne for iron ore – this is the cheapest in the industry – when prices plummet to $40 – they are still making $28 – a good margin – when the prices are around $125 – they are making a killing
         1. The next best is Fortescue with $15 per tonne – but that $3 is still a large difference – 25% more in costs
      3. This comes with economies of scale – which leads into the second competitive advantage
   2. Size Advantage - Being big can sometimes, in itself, create an economic moat for a company
      1. At a certain size, a firm achieves economies of scale where there can be synergies between businesses – or they can control the supply chains as well
      2. This is when more units of a good or service can be produced on a larger scale with lower input costs. This reduces overhead costs in areas such as financing, advertising, production, etc. Large companies that compete in a given industry tend to dominate the core market share of that industry, while smaller players are forced to either leave the industry or occupy smaller "niche" roles.
   3. High Switching Costs – This is a tricky tool that companies can use – increase the costs to switch between them and their competitors products
      1. Thinking about Apple and Android for a second – I have had a Samsung phone for about 13 years now – after having an iphone for about 2 years prior – I made the switch, but I remember the difficulty in not only switching IOS – but also the transfer of contacts and data – it is almost like starting from scratch
      2. This is where the size advantage can also come into benefit - When a company is able to establish itself in an industry, suppliers and customers can be subject to high switching costs should they choose to do business with a new competitor. Competitors have a very difficult time taking market share away from the industry leader because of these cumbersome switching costs.
   4. Intangibles - Another type of economic moat can be created through a firm's intangible assets, which includes items such as patents, its brand, government licenses and other factors which give it the edge over competitors – such as loyalty
      1. Strong brand name recognition allows these types of companies to charge a premium for their products over other competitors' goods – generic brands versus the house hold names -
      2. Patents or IP can also block any competitors from entering your industry
   5. Barriers to entry – This can either be in the form of legislative restrictions or a high cost of capital to enter the industry
      1. Airlines are an example – as well as other highly regulated entities – can have not only legislative hurdles to overcome, but also upfront capital –
         1. Which can be hard to raise – either need wealthy investors, or banks to lend – which they are not that likely to do unless it is a low risk enterprise for them – smaller loans of $1m are not too great a risk – but loans in the hundreds of millions to start a larger company are almost impossible for a start up to come by
      2. Soft Moats - Some of the reasons a company might have an economic moat are those factors which are harder to quantify – this might be from exceptional management or a unique corporate culture – this is because a unique leadership and corporate environment can contribute to a company’s ability to generate a competitive advantage, adding to their success and profits

Economic moats are generally difficult to pinpoint at the time they are being created. Their effects are much more easily observed in hindsight once a company has risen to great heights.

From an investor's view, it is ideal to invest in growing companies just as they begin to reap the benefits of a wide and sustainable economic moat. In this case, the most important factor is the longevity of the moat. The longer a company can harvest profits, the greater the benefits for itself and its shareholders.

1. Many of the best businesses often encompass more than one of these economic moats – let us look at a hypothetical example -
   1. Say there is company A – and they have sent all of their production overseas, whilst there competitors are domestic – this has reduced their labour costs and costs of production by around 40% - this allows them to undercut the prices of competing companies producing the same product
   2. This low prices lead to an increase in the number of customers buying your good, as you are now – lets say 20% than the next competitors for the same product – from this - you see an increase in profits
   3. But - it probably wouldn't take very long for your competitors to notice that you have offshored and follow suit – therefore, now their cost decreases can match yours – and they can likely drop prices by around 20% more – or lets say they go to 25% decrease – which would eat into their profits by still make an additional profit of 15% instead of 20% - These other produces would start to lower this companies market share and profit – in response they may need to lower their prices as well
   4. However – lets say that you have been using your profits and investing in R&D – you develop a new technology that allows you to get 30% more efficiency out of your product – making it 30% better for the same price
      1. Over this time, your competitors will have no way of duplicating your methods – therefore, your competitive advantage is protected by your patent
      2. So in the end – your economic moat is the patent that you hold – not that you started producing overseas at a lower price
   5. In the end - a company's economic moat represents its ability to keep the competing companies at bay for a longer period of time – in a way that is not easily replicable
      1. As the strategy of offshoring was replicable – but the patent isn’t
      2. The interesting thing about moats is that they have no obvious dollar value
   6. Real world examples – Amazon –
      1. Cost – Amazon have developed a low cost offering – often delivery is nothing, or lower cost than something like Aus post – the goods prices are also often the lowest in the market – due to supply chains that are straight to the producers
      2. Size – due to size, they have a massive distribution network – can get you anything, and in the quickest time
      3. Intangibles – have a major brand name – would have to go to some Amazonian tribe to find someone who doesn’t know amazon – ironically talking about the company here
      4. soft moats – the soft moats relate amazons ability to lobby and have a legal department in every state to petition the local politicians for lower taxes and some subsidies to take business to the state – many other businesses don’t have the clout of amazon to negotiate such deals
   7. These moats are all well and good – but how do they stand up over time - One of the basics of competitive market theory - is that, given time, competitors will adopt and adapt your practices – this can erode any competitive advantages enjoyed by a firm
      1. This is more likely to occur in nations with relatively free markets – where firms are allowed to competing for competitive advantages – if any company innovates and adopts a superior model – at a lower cost or better product – then other companies will copy as soon as possible – in a truly free market – there is nothing to stop these companies – therefore in the long term – it would be almost impossible for any company to maintain a long term competitive advantage – it would be gone, and better for us – we get better goods and lower prices
      2. But when it comes to a monetarily and politically controlled economy we live in – where do you look for competitive advantages – as they do exist – and are actually easier to pick than in a truly free market
      3. Frist – look for any companies with superior operations – this can mean that have the market share of sales, or excess profits in their industry, or the brand name recognition –
         1. The reason these two are important is that they are outside of normal market competition – existing larger companies have a competitive advantage over other companies that don’t have the same political or economic influences that they do – this does disrupt what would occur in a theoretical free market – so reality does need to be accounted for
         2. It is important to identify what moats of the business are likely to last – and which can be replicated – i.e. is it a shift in business practice which can be easily replicated – or is it some form of competitive advantage that allows this company to stand alone

• Things like businesses practices can be replicated – but the political connections and lifeline protections are harder -

This leads into the application of identifying moats and selecting shares

1. Say you have identified a company with a moat – does this mean that you rush in and buy? Technically not – the second part of moat investing is all about the fair value of the company –
   1. This is where this style of investing does require some degree of value investing applied to it – so if you identify a moat company that is priced at $40, but has a fair value based around future cash flows of $30, you may not purchase this company
   2. This is for one major reason – back the concept of a moat – for defensive purposes – therefore, being more defensive, investors would purchase at a below fair value – or at the very least, not at a 30% increase in value
2. In the end - The goal is to not just find businesses that have moats, but undervalued businesses that have moats – this is easier said than done -
3. This strategy does sound great – but how well has it actually performed – due to being a value-based approach of undervalued businesses who possess a moat – a moat value investment strategy has underperformed other strategies
   1. Over the past few decades – when measuring purely based on return - index or a growth approach would have performed better
   2. This is where if a company has a real moat around it – it likely isn’t trading below fair value – other investors would have identified the moat and purchased around this –
4. an important factor may be ignoring the fair value approach – but at the same time not blowing it out of the water –
   1. Traditionally – fair value is paying a sum less than the fair value – but what about purchasing at the fair value – or 10% above?
   2. This is the real problem with this strategy – unless this is your fulltime job – the market will likely notice the moat before the individual investor
5. So how do you apply the use of moats when it comes to investing –
   1. Individual shares – You can spend some time understanding the individual shares, or there are also some researchers that provide a moat rating – like Morningstar and you can get an idea of a company’s potential from sites like simply wall street – these can be a useful tool
   2. Active managed funds – You can look at some fund managers who use moats and value approaches – or at the very least a moat approach – especially in the large to mid-cap of the market this strategy has historically worked well to protect a downside
   3. ETFs – There are a few ETFs that tilt a portfolio to focus on certain factors, like moats through the quality of the companies

Summary - All businesses have some sort of competitive advantage – especially once they get to the size of being listed on the market

1. So, it can be side to assume that once a business has grown and survived long enough to get listed on a share market – there is some advantage – but is it a long-term competitive advantage? Or can competitors catch up and perhaps even overtake it?
2. The idea of moat investing is to identify companies with competitive advantages that can persist long term and then invest if the price is attractive
3. This can help a portfolio limit risks where the underlying investments can maintain their market share and continue to deliver performances

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