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The financial news has been dominated by the growth-to-value transition since the start of the year. We’ve long said there’s no purpose to having two separated camps. So rather than treating them as extremes, we can incorporate both hand-in-hand.
Below I added a photo of Angkor Wat, a religious monument in Myanmar.
You can see the moat this building has. The moat is the water surrounding the property. A moat would make it difficult for an attacker to infiltrate back in the day. After all, they will have to pass the body of water that encircles the property.
A moat is a typical defensive component of a castle (medieval Europe) or an equivalent building elsewhere.
An economic moat is a protection a company has against uprising competitors. A sustainable competitive advantage helps a company achieve higher profits over a longer time span. This term was initially coined by Warren Buffett.
Mr. Buffett recalls the story when he discovered that they had to pay Google a fee for every click on the Geico link from Google. He noticed that Google built the best algorithm and thereby built its brand. As the network scaled, so did the profits for Google. The moat they have created allows investors to have predictable insights into future performance and the company’s valuation.
They didn’t get the memo… algorithm > callgorithm.
There are four key categories of economic moats and 2 other types of “soft moats.” We’ll go through each one by one. Understanding this concept allows you to better value a company with the insight to better predict future performance.
An intangible asset is an asset that allows for a price advantage without being of physical nature. An example of this is a patent. Patents are widespread in the pharmaceutical business.
In 1993, Pfizer was issued the patent for Lipitor, a cholesterol-lowering drug. They started marketing Lipitor in 1997, and the patent remained active until 2011. In these 14 years, Pfizer generated well over $100 billion in revenue from this patent. Although the product it protects is physical (the medicine), the moat was the patent that others couldn’t infringe upon.
Another example of an intangible asset is brand value. This is very common in the diamond business. No matter what brand they’re from, Diamonds all follow the same grading structure. The most common grading certificates come from GIA, the Gemological Institute of America.
A round 5ct D-VVS 3X diamond will cost approx. $150,000 at the dealer’s wholesale price. If you were to purchase the same stone in the Graff store, you could expect to pay between $700.000-$900.000. As you walk out of the store, all you got is the exact same GIA certificate that you’d get on the wholesale deal. You’re paying 5-6X the value solely for the pretty presentation box and the glass of champagne you get in-store. That’s brand value, an intangible asset.
Laurence Graff, the owner of Graff Diamonds, is worth approx. $4 billion. I occasionally see him in Gstaad (CH) surrounded by beautiful women. He built Graff into a brand, although diamonds are basic commodities.
Btw, this was me in Antwerp last month (masks were required). The building behind me is the Diamanten- Beurs, the World Diamond Exchange. It’s like a trading pit, but for diamonds. Unfortunately, as with every trading pit, it’s lost its charm and is now a place for friends to play a game of chess and discuss work.
Nonetheless, Antwerp is the diamond capital of the world. 84% of the world’s diamonds are traded through this city. The small street on which all the action takes place, the Hoveniersstraat, is home to
thousands of businesses. It’s entirely controlled by the Indians and Haredi (Orthodox) Jewish. One of my dear friends, who’s been a diamond trader for decades, gave me an insight into how everything works. This might be the topic for another story.
Before I drift off, my point is that the value of a brand, like Graff, allows it to charge multiple premiums for a simple commodity. That’s brand value, and that’s a moat. A diamond trader can’t charge more than wholesale, but a brand image allows that opportunity.
Within your local region, you’ll see many companies with a moat. It might be that restaurant with a liquor license that others can’t get. It could be a casino, a trash belt, a weed dispensary. Anything that permits is rarely given out can create a moat for those who have it.
Autodesk has a market cap of $50 billion. Autodesk develops and distributes engineering software. Their software applications are specialized for sectors like architecture, manufacturing, construction etc.
I can attest that its software application for automotive component design is highly complicated. As I was working in Asia, we had 100+ engineers that had to work with Autodesk’s software application all day long.
It takes a design engineer hundreds (if not thousands) of hours to become an expert at using Autodesk.
What if the company decided to switch from Autodesk to another software? It’d be a nightmare for its design engineers. They’ve spent countless hours working with Autodesk. Any change to a different software would set them back significantly.
This is “customer switching costs.” Once clients have a specific program deeply integrated into its processes, it becomes hard to change.
The same counts for plenty of other businesses. You won’t see a bank changing its cybersecurity partners every year. Once a service is deeply integrated into its systems, switching costs become too high. It’s not just the financial cost; it’s also the time and risk costs.
Neither does a private individual change their bank account or insurance provider every year. People will change fashion stores and restaurants all day long. Still, the customer switching costs for an umbrella insurance policy are different.
The world’s most valuable public company, Apple, is a prime example of customer switching costs. Many users are fully embedded in the Mac ecosystem with their Macbooks, iPads, and iPhones. They’re familiar with the Apple iOs systems, and the effort to switch to Windows simply isn’t worth it anymore.
The network effect is one of my personal favorites.
There’s no better example than a credit card provider. Visa and Mastercard need to push stores to accept their cards. As a result, users will get their cards because the stores accept them. Once you reach scale, every new store will take Visa and Master because every user has Visa and Master, which goes vice versa. Once the network effect has been successfully executed, it will develop further on its own.
The value of the product increases with each additional user.
This is why eBay can charge 10% off every sale. They created the network effect and thereby have the most sellers and buyers in one place. It’s hard for any competitor to compete, as it requires scaling on both sides.
The cost advantage moat speaks for itself; it’s the ability to deliver a product at a lower cost.
If you need to ship a package in the US, you’d be using one of the three majors. So, you got UPS, FedEx, and USPS. At a time, DHL wanted to be fourth, but they were losing against the cost advantage of its competitors in the US.
However, FedEx is less common in Europe, where DHL is the big giant.
It all comes down to scale. If UPS can deliver 200 packages a day in one neighborhood vs. DHL at 5, UPS can do so at a lower cost per package. It’s unlikely a new shipping company will replace UPS in the US because the losses they’d have to carry to reach the same scale would be unsustainable.
The same applies to physical products. For example, nuclear energy is powered by Uranium. The world’s largest miner, Kazatomprom in Kazakhstan, can
mine Uranium 30-40% cheaper than its largest competitor. For this reason, the cost advantage of KAZ gives it a moat in the uranium mining industry. The recent political chaos, of course, affects KAZ, but that was an outlier event. It doesn’t affect the mining costs for KAZ; it solely affected mining schedules & operations for a while.
Having Tom Brady on your NFL team or Haaland as a striker for your football club gives a team a moat. Albeit small, it undoubtedly is a competitive advantage to have them on board.
This is about having key individuals that can make a difference. Elon Musk makes a difference at Tesla and SpaceX. Jeff Bezos makes a difference at Amazon.
These leaders developed a vision and executive strategy and appointed the right people to execute upon that. This type of leadership is a soft moat for a company.
Elon Musk himself famously stated that “moats are lame. what matters is the pace of innovation, the fundamental determinant of competitiveness.” Well, I definitely do not agree with everything that he says or does, and the market has also shown to disagree. It’s not easy to out-innovative Kazatomprom’s geographic/natural competitive advantage or out-innovate UPS’ scale moat. Nonetheless, it does highlight another soft moat: innovation.
Leadership, management, corporate culture – these factors all influence the strength of its moat.
One forest might make you more money than the other if you’re acquiring a forest for carbon offsets. This is because trees grow differently in different regions. For example, natural development can go twice as fast in Brazil as in Germany, so it has a natural competitive advantage.
Suppose a heavy natural resource is closer to the end clients than its foreign competitors. In that case, it will have a geographic moat.
The illustration above summarizes the moats we’ve discussed. To some, this might have been a boring read.
I think it’s important to consider these aspects when valuing a company. Otherwise, you’ll end up with a Rivian or Lordstown stuck in your portfolio…
There’s only one lesson I want you to take away from this.
At times, it’s alright to pay a premium for a sustainable and robust moat in a company. After that, it simply becomes a question of margin of safety vs. opportunity cost.