WHAT DOES HAVING A ‘MOAT’ MEAN IN INVESTING?
Q: In a fast-changing world of hightech and geopolitical challenges, can you explain what having a “moat” means today? How can a small investor know if a company has a sustainable competitive advantage? — Cassandra
FP Answers: Sustainable value creation has two parts: the magnitude of returns in excess of the cost of capital, and how long these excess returns can be sustained by the company.
Like a farmer who uses a winnowing basket to separate the wheat from the chaff, a successful investor must identify companies with the potential to generate economic value added (EVA) over the long term. One way to do this is to focus on businesses with strong economic moats. It was value investor Warren Buffett who popularized the term “economic moat” when he said, “A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital.”
Just as a castle’s moat defends against intruders, having a durable competitive advantage (moat) that gives a company strong pricing power makes it harder for challengers to steal market share away from it and harm profits.
As the late Charlie Munger said, “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six per cent on capital over 40 years, and you hold it for 40 years, you’re not going to make much different than a six per cent return — even if you originally bought it at a huge discount.”
Last year was a bumper year for moats as companies were dealing with the POST-COVID-19 effects of rising inflation and interest rates, as well as geopolitical tensions that gave way to supply chain issues and economic uncertainty. It’s no wonder the use of the term “moat” in earnings calls spiked to a historic peak as business leaders sought to reassure investors about their company’s longterm strength and profitability.
But in a fast-moving world, how can investors know whether a current market leader will become a laggard?
Companies can build a wide moat in at least five ways and those with wide moats often have several of these factors: high switching costs, intangible benefits, network effects, competitive pricing and efficient scale.
High switching costs make it harder for customers to change service or product suppliers, which benefits the incumbents. A good example is the software industry, where solutions are embedded into the client’s core business processes, making it difficult and expensive to migrate to a different platform.
A Canadian example is Sylogist Ltd., a large holding within the Pender Small/mid Cap Dividend Fund. Sylogist is a software-as-a-service (Saas) company with more than 2,000 public-sector customers, including non-profits, K-12 education and governments.
The management team is committed to profitable growth with over 63 per cent of its recurring revenue consisting of Saas subscription and maintenance and support. The fully integrated, mission-critical software offered through the cloud makes its customers sticky, as represented by its gross customer retention ratio, which, at around 95 per cent, is much higher than its Saas peers.
Intangible benefits could include attributes such as “brand love.” Certain brands engender customer loyalty and affection. Brands such as Apple and Hermes create covetable goods that have a strong cachet, and engender a feeling of community among consumers that give their businesses a high level of immunity from competition. Other types of intangible assets include patents, copyrights, regulatory licences and government tariffs.
A Canadian example we added recently is Aritzia Inc., a multi-channel fashion retailer with an innovative global platform offering everyday luxury products sold in aspirational environments with engaging service and captivating communications. Aritzia has a track record of profitable organic growth and free cashflow generation that underpins its financial foundations. Capitalizing on the availability of premier real estate, it is growing its boutique network across North America with a focus on the United States.
Efficient scale works to the benefit of incumbents when it bestows upon them competitive advantages that will be difficult to overcome, thus creating a virtual monopoly or duopoly. The high costs of launching into such an industry would lower returns below the cost of capital for new entrants. An incumbent might also enjoy geographic advantages that are hard or impossible to replicate.
A Canadian example, and a holding within the portfolio, is Firstservice Corp., which offers outsourced property services in the U.S. and Canada. Its scale advantage, proprietary products/services and national coverage are competitive differentiators that are difficult to replicate. It has consistently earned a return on equity in the high double digits, which, when combined with its more than 25-year track record of growing revenue at a compound annual rate of growth of 19 per cent, makes it an attractive investment.
Network effects make a business more valuable as more people engage with it. The classic example here is Meta Platforms Inc., whose Facebook and Instagram divisions attract billions of users. Alphabet Inc. is another example since its Google search engine captures more than 90 per cent of the global internet search market.
These massive user bases attract lucrative advertising revenue and allow the businesses to raise prices. And they make it hard for new entrants to steal market share.
Competitive pricing is another way to create a moat. If a business is strong enough, it can negotiate with its suppliers to get cost reductions or it can produce goods at a lower cost through efficiencies. It can then undercut the competition or benefit from higher profit margins. Either way is a win for the company. Some examples of companies with strong pricing power are Costco Wholesale Corp. and Walmart Inc.
Profitable businesses and industries are bound to attract competitors. Companies with strong moats are better able to keep competitors at bay, or at least long enough to adapt their business models to a new economic or technological reality. Looking for those quality companies with strong, wide moats is a good place to start for investors seeking to build durable, all-weather portfolios and long-term wealth.