Brian Bares on creating a moat in investing style and strategy.
also Pat Dorsey on identifying moats in businesses.
The basic points I gleaned from both videos,
BUILDING AN INVESTMENT STRATEGY WITH A MOAT (Bill Bares)
Moat doesnt equal edge
A moat is how hard it is to replicate what you do
Differentiation may not lead to outperformance.
What is an investment edge?
Repeatable sourcing of variant perception that leads to sustained outperformance
Sources of variant perception,
Informational
Analytical
Behavioural
Not much edge in informational, this is where market is pretty efficient
Analytical is the big edge, we all have similar info, its what we do with it, especially on a qualitative basis. Repeatable.
Behavioural, based on market psychology, makes sense, but no one seems to do it successfully, very difficult to implement consistently. (probably because of the very biases you are looking for.)
Turn arounds, market mispricings due for fear or greed.
Two pillars of investment process
Building a differentiated investment process that is hard to replicate - Moat
Creating Repeatable sources of variant perception that should lead to outperformance. -Edge
COMPETITIVE ADVANTAGE / MOAT AT A BUSINESS LEVEL - (PAT DORSEY)
Capitalism seeks the highest returns possible, high profits attract competition.
Most businesses with high returns on capital will see returns decrease over time
But a small minority will enjoy many years of high returns on capital - because moat & edge.
They do this by having some form of structural advatage that makes competing on price difficult.
Great tech or great products are not moats/edge - think crocs!
Economic moats are structural and sustainable qualities that are inherent to the business.
Not hot products - popular toys, Krispy cremes
Not cool tech, if it can be easily replicated it will be.
Its not big market share, the only time market share can be a moat is when its anti-competitive, eg monopoly or duopoly protected by externalities. (geographic, legislative)
Moats generally manifest themselves in pricing power, a company that cant raise prices is unlikely to have a strong moat
Exception is if you have a moat based on scale (rare) then driving price down to force competitors out of the market can be a successful strategy of businesses with a moat.
TYPES OF MOATS
Intangible assets
BRAND
Increasing willingness to pay more or lowered search costs.
This must exist in one form or the other - would you pay $1500 more for a Sony TV over Panasonic?
Brand must change consumer behaviour to be a moat.
Brands are valuable if they deliver a consistent and or aspirational experience.
Dont change product and give people a reason to change brand, new coke, new pizza shapes
Create scarcity and exclusisivity. Restrict availability of new products etc. iPhone releases
Online brands involve trust for obvious reasons so a trusted online brand has an advantage beyond price, eg Amazon customers typically dont look elsewhere even though it would be easy.
PATENTS
probably need lots of them to provide any sized moat
Licenses and approvals
casinos, landfills,
SWITCHING COSTS
Does the cost of switching to a competitors business outweigh the advantages? (or at least not be advantageous enough to bother,)
Integration with customer business, high upfront cost to switch, payback from renewals - MYOB, Office 365,
Service contracts for expensive infrastructure - eg lifts.
Input costs that are fractional, allows you to price set. eg an additive that greatly improves product, small unit cost, big value, you can increase costs easily. adhesives, fastners, lubricants, enzymes,
NETWORK EFFECT
Provide a service that increases in value as the number of users increases. Facebook because of advertising.
Aggregated demand b/t fragmented parties. MC & Visa, ticket clippers, barrier to entry very high
See it with distributers, connecting fragmented suppliers with fragmented retailers. DDR.
COST ADVANTAGES
Find a cheaper way to deliver a product that cant be replicated quickly/easily
Scale, spread fixed costs over a large base, obviously suits a business where fixed costs are a high % and variable costs are low. Relative size matters more than absolute size = Australia Post
Niche, minimum efficient scale. Things like very specific and embedded software solutions, (maybe CDA?) - emergency services comms software, maybe ADA? Flight simulators.
MANAGEMENT
A good jockey will do well on a good horse but not on a broken down goat.
A poor jockey on a racehorse will beat a great jockey on a goat, if he can just stay on the horse!
Managers matter in the context of the moat.
The required level of managerial skill is inversely proportional to the quality of the business
Bad managers invest capital outside a company’s moat, lowering overall ROIC.This process is called deworsification or burning piles of cash.
An exception to every rule
A tiny minority of great managers can create enormous value via astute capital allocation even if they dont start with great horses. (buffet, textile mills)
Moats in a global context.
Local differences can create moats
Minimum efficient scale is more common, (woolies & coles) basically niche markets
WHY MOATS MATTER
They add intrinsic value
A firm that can compound cash flow for many years is worth more than a firm that cant
The value of a moat is largely dependent on reinvestment opportunities, the ability to reinvest loads of cash at a high incremental ROIC is a very valuable moat.
If a company has limited ability to reinvest, the moat adds little to IV. It does add certainty and confidence to the IV.
Moaty businesses that generate cash are good, ones that can reinvest cash are amazing!
Overestimating the moat means you may pay for value creation that never materialises.
Underestimating the moat means paying a large opportunity cost.
Isnt the moat already priced in?
Less often than you think.
Short termism.
Quantitive data is efficiently priced
Qualitative insight is less efficiently priced.
“All of the information is in the past, all of the value is in the future”
