Capitalism Works

• Capital seeks the highest returns possible: High profits attract competition.
• So....most businesses with high returns on capital will see returns decrease over time.

Moat Basics

• Economic moats are structural & sustainable qualities that are inherent to the business.

  • Not hot products. (Heelys? Krispy Kreme?Sugar is a moat)
  • Not just a cool piece of tech (lomega?In tech there will be a newer with more advanced product)
  • Not the biggest market share (GM? Compaq?)

• Moats generally manifest themselves in pricing power: A company that can't raise prices is unlikely to have a strong moat.

INFO: We looked at companies that maintained Return on Capital above Cost of Capital for 15+ years.

• What are the common characteristics of these business
• Whats the similarities in these business

Intangible Assets

• Brands

  • Increase willingness to pay / lower search costs
    • Sony(Tech product:who buys VCD Players) vs. Tiffany(Diamonds, its worth it)
    • Amazon, Groupe Richemont, Coca Cola İçecek

• Patents

• Legal monopoly vs. expiry/challenge/piracy

  • If one drug is driving all the economic value, if that patent is getting challenged, you are dead. So, you have to be very careful.
  • Novo Nordisk, Qualcomm, Chr. Hansen

• Licenses/ Approvals

  • Legal oligopoly vs. regulatory fiat
  • Casinos(limited licenses), landfills(nobody likes to live there, less number licenses), aircraft parts(Most of the parts are made by one company, good business)

Widening the Moat: Brands

• Brands are valuable if they deliver a consistent or aspirational experience.

  • Consistency lowers search costs & drives loyalty. Don't change & give people a reason to switch!
    • Mistake: New Coke, The Schlitz

• Aspiration increases willingness to pay. So, create scarcity & exclusivity. +Tiffany's store layout(40% revenue comes from stuff that costs less than $200 and shop layout is like costly items in front and cheap at last) +"You don't own a Patek Philippe, you merely take care of it for the next generation."

Confidence is how other people see you.

Switching Costs

• Does the cost of switching to a competing product or service outweigh the benefits?

  • Integrate with customer's business: Upfront costs of implementation payback from renewals

    • Silverlake Axis, Oracle, SimCorp
    • Migrating to Oracle to another database is a expensive thing for a multi-national company, they will not go for it. So, lock-in is a good thing.

  • Sell ongoing service relationships

    • Rolls Royce, Otis, Kone, Schindler
    • Kone is a elevator company, once a elevator is setup, its not coming out. Rolls Royce, sells JetEngine they change you by the hour. You pay is related to how much you use it.

  • Provide a product with a high benefit/cost ratio

    • Fastenal(Makes bolts, product doesn't cost much, but brings huge economic cost to the company), Ecolab, Novozymes, Fuchs Petrolub
    • Lubricant which improves performance of a mining machine, that lubricant costs less when compared to the actual machine or production, so even if they increase 20%, they will pay for it.

The Network Effect

• Provide a service that increases in value as the number of users expands.

  • Aggregate demand b/t fragmented parties.

    • Edenred, Henry Schein(used by dentists), XPO Logistics

  • Non-linearity of nodes vs. connections.

    • Visa, Mastercard, Facebook

• Western Union is Radial, they have lots of branches but nobody is sending money from Bangladesh to Chicago or Mexico

Cost Advantages

• Process: Invent a cheaper way to deliver a product that can't be replicated quickly.

  • Inditex, RyanAir, GEICO, Dell

• Scale: Spread fixed costs over a large base. Relative size matters more than absolute size.

  • UPS, Aggreko, Stericycle

• Niche: Establish minimum efficient scale

What About Management?

• "Good jockeys will do well on good horses, but not on broken-down nags." (Buffett)

Moats, Management & Mistakes

• Moats can buffer management mistakes
  • Microsoft minted money despite Steve Ballmer
  • New Coke didn't kill Coca-Cola
  • Moodys put profits before integrity, and still cranked out a 40% operating margin
  • But even a genius like David Neeleman couldn't change that fact that JetBlue is an airline - the worst industry known to mankind.

The Good & the Bad

• Good managers are constantly looking for ways to widen a company's moat

  • Amazon's focus on the customer experience(There is a lots of trust involved)
  • Costco's focus on using scale to lower costs

• Bad managers invest capital outside a company's moat, lowering overall ROIC

  • This process is called "deworsification," or "setting fire to large piles of cash."
  • Example Cisco -- Starting a consumer business, Garmin -- Starting a GPS Handset business(Every phone has GPS)

An Exception to Every Rule

• A tiny minority of managers can create enormous value via astute capital allocation - even if they don't start with great horses.

  • Warren Buffett (Berkshire), Brian Joffe (Bidvest), Dick Kovacevich (Wells Fargo), Steve & Mitch Rales (Danaher)

• They are hard to find, and false positives abound...but they can create enormous wealth over time. Keep an eye out!

Valuing Moats

• The value of an economic moat is largely dependent on reinvestment opportunities

• The ability to reinveset tons of cash at a high incremenetal ROIC = a very valuable moat.

  • Fastenal, XPO, Curro

• If a firm has limited ability to reinvest, the moat adds little to intrinsic value. +McCormick, Microsoft, Oracle

Isn't Moat Already Priced In ?

• Moats usually matter in the long run than in short
• Most investors assume the current state of the world persists longer than it usually does.

Finding Moats = Finding Inefficiency

• Quantitative data is efficiently priced in
• Qualitative insight is less efficiently priced

Moats in a Global Context

• Local differences create moats

  • Canadian banks, Edenred, German car washes

• Minimum efficient scale is more common South African retailers, Globo, BEC World

• Cultural preferences create barriers to entry Beer travels. Candy & snacks generally don't.

# References

• Wealth Education