September 10, 2014

What is an Economic Moat?

So what exactly is an economic moat?

While many subscribers are likely familiar with the concept of economic moats, some may find it foreign. Since the term is a key framework we use, let’s discuss it. In this post, we will provide an overview of the concept and provide some insight into how we use it in our analysis.

Let us begin with the term as explained by Investopedia:

“The term economic moat, coined and popularized by Warren Buffett, refers to a business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.”

The term has gained attention over the past few decades because it contradicts a core part of economic theory: that high profits attract competition which ultimately reduce profits to the point where returns equal a firm’s cost of capital.

Since coined by Buffet decades ago, the term economic moat has been widely used to describe structural advantages that have allowed firms, such as American Express and Coca-Cola, to elude these competitive forces and earn outsized profits for many decades. The concept has been further built on by investment research company Morningstar and distinguished Columbia University professor Bruce Greenwald in recent years and is now commonplace in many business analyses.

The term “economic moat” is often used interchangeably with “competitive advantages” but there is in fact a key difference between the two. Competitive advantages refer to a business’ ability to currently earn excess profits over its competitors. It is the durability and sustainability of these advantages that afford the firm a true economic moat – the ability to earn excess profits over the long-term. This may sound nuanced, but the difference can be on the order of billions of dollars through the wonders of compounding over many years.

Competitive advantages are commonplace in business and are often the result of technological breakthroughs, hot products, or superior manufacturing processes and operational efficiency. While initially a boon for the business, advantages such of these often prove transient as competing firms catch up with the technology or flood the market with comparable products. Consider the recent example of Blackberry Ltd, who pioneered the smart phone market and earned extraordinary profits only to have its market share decimated by superior products from Apple and Samsung.

Such a situation can prove disastrous for investors, especially if the price paid for a company reflects expectations of continued excess profits far into the future. True economic moats, on the other hand, are often structural in natureand far more likely to provide the firm with an edge over competition over a long period of time.

Sources of Economic Moats

So where do these economic moats come from? Interestingly, there are only a few identifiable sources that have proven capable of creating this desirable condition. Consistent with the methodology outlined in Bruce Greenwald’s “Competition Demystified,” we view the sources in two categories, supply side and demand side.

Supply Side Sources

Supply side refers to the advantage of producing with a lower cost structure that cannot be duplicated by potential rivals. Sources include:

Proprietary Technology – in this case patent protected production technology affords the firm the ability to produce most efficiently and supply at the lowest cost. Patent infringement and legal fees keep competitors out during the life of the patent. Famous examples include Xerox in copiers and Alcoa’s patented aluminum production process that afforded it near monopoly status for many decades.

Geographic Advantages – in this situation, location provides a firm with privileged access to raw materials, which affords it lower input costs compared to its competitors. Examples include Compass Minerals’ ultra-low cost rock salt mines and Vulcan Materials’ gravel quarries. Other cases are situations where a given location can only support one supplier, such as an airport or marine port.

Demand Side

Demand side refers to customer captivity that makes it difficult for an entrant to lure away an incumbent’s customer base. These result from:

Brands –positive customer associations with a particular product result in repeated purchase and an aversion to switching to competing products. Selection of a particular brand becomes habit-forming and presents a formidable challenge for an entrant attempting to lure away loyal incumbent customers. Well-known examples include many household products such as Coca-Cola, Hershey’s Chocolate, and Gillette razor blades.

Switching Costs – customers will be reluctant to change providers if it requires substantial time, money, and effort. A customer will be highly unlikely to go through the effort to learn new computer software, such as Microsoft Office, even if promises superior functionality. Another example would be switching bank accounts, which involves considerable hassle and introduces the risk of missing automatic bill payments, credit card payments, etc.

Searching Costs – a customer will be captive if it is difficult to locate a suitable replacement to an existing supplier. Locating a new doctor, for instance, cannot easily be done with an Internet search – especially given the personal nature of the relationship required. While economic moats are almost unheard of in the retail industry, AutoZone has been able to charge premium prices due to infrequent purchases by customers and the cost involved in searching for competing products when one’s car is out of commission.

Network Effect – this powerful force results when each customer joining the network increases its value to all other users. Each new merchant joining EBay strengthens the marketplace, each of your friends to join Facebook makes the social network more valuable to you, and each company to list on the NASDAQ stock exchange increases its appeal to investors. The network effect often breeds a virtuous cycle where a company reaches a critical mass, rendering potential entrants with the near insurmountable task of making inroads in an incumbent network.

One additional source of economic moats is government protection through patents, licenses, or special recognition. Moody’s designation as a “Nationally Recognized Statistical Rating Organization,” has allowed it to earn outsized profits, as has Fannie Mae’s backing as a “Government Sponsored Enterprise” (GSE). Investing on grounds of government protection requires due caution as investors are subject to the whims of the government which can result in moats evaporating almost instantaneously following legislation changes.

Advantage by economies of scale is worthy of its own class as a source of economic moats and can provide a firm with sustainable long-term competitive advantages over its competitors. Economies of scale refer to a firm’s ability to spread fixed costs over a large amount of volume, thus reducing unit cost. Provided a firm is significantly large relative to its competitors, it will be able set a price level that will render its’ competitors unprofitable.

Economies of scale are especially powerful when combined with one or more of the sources of economic moats described above. In this situation, entrant firms will have considerable difficulty building their customer base to a point where the scale advantages of the larger incumbent begin to erode.

It is interesting to note in our vast and dynamic economic system, all known sources of economic moats can be described by the few discussed above. Plenty of firms go through periods of abnormal profitability but without one or a combination of the characteristics described above, such times are virtually certain to be transient. Competition makes absolutely sure of this. With so few sources capable of creating an economic moat, it no wonder they are rare and their search is so rewarding.

Testing for an Economic Moat

So now that we know the sources of economic moats, are there ways to test for them in practice? The litmus test here is a firm’s unleveraged return on invested capital, especially viewed over long periods of time. This term appears in many forms but we suggest a definition similar to that proposed by Joel Greenblatt:

ROIC = (EBIT + interest embedded in operating leases) / (Operating current assets – operating current liabilities + net fixed assets + capitalized operating leases)

This calculation allows the underlying economics of the business to be gauged independent of financing decisions or acquisitions by management. It should be cautioned that a high ROIC is only an indicator of an economic moat. As sure as night follows day, capital follows high returns to compete them away. The key is judging the sustainability of ROIC along with the sources of competitive advantages at work to arrive at an assessment of the durability of the moat.

While ROIC is readily calculated and analyzed, the next test requires a bit more finesse. Next up is pricing power, the ability of a business to raise prices without significant customer attrition. Pricing power is rare in a competitive marketplace and usually indicates a high degree of customer captivity, a key source of an economic moat.

Warrant Buffet famously relied on captive customers of his See’s Candies to consistently raise prices for decades. As Buffett explains in the 1986 Berkshire Hathaway letter to shareholders, he was confident in his ability to do this because:

“See’s has a one-of-a-kind product “personality” produced by a combination of its candy’s delicious taste and moderate price, the company’s total control of the distribution process, and the exceptional service provided by store employees”

Pricing power also provides the ultimate inflation hedge as companies like Coca-Cola and Kellogg’s have been able to tap their powerful brands to raise prices almost at will and combat rising commodity costs.

Analyzing a firm’s ROIC and pricing power will go a long way to determine the presence of an economic moat. Additional indicators, such as high profit margins and high free cash flow (FCF) generation can also serve as clues for the presence of an economic moat. A company that needs to spend very little in the way of capital expenditures to retain unit volume will have high free cash flow and may be the beneficiary of an economic moat.

The key in our experience is to employ both a quantitative and qualitative assessment in gauging a firm’s economic moat. Investing under the pretense that high returns on invested capital are equivalent to a durable economic moat can have disastrous consequences.

Conclusion

In conclusion, economic moats offer a powerful framework for selecting attractive investments for the long term. Quantitative clues such has high unleveraged returns on capital, high profit margins, and high free cash flow generation combined with a qualitative assessment of the sources of economic moats can provide investors with important clues as to the future cash flow generation capability of the company. Estimating future cash flows is essential for arriving at an appraisal of intrinsic value and making informed investment decisions.

As we have seen, economic moats arise from only a handful of sources and are indeed rare in the business world. The few companies fortunate to qualify as wide moat businesses often trade at generous valuations which adds an additional element of risk for investors choosing to invest in these companies. Nonetheless, uncovering such a business at a reasonable valuation can lead to outsized returns over many years and has formed the basis of Warren Buffet’s strategy for last few decades.

So there you have it, our take on Economic Moats 101 in just over 2000 words – albeit without much in the way of original ideas on the subject.