Searching for Emerging Moats

Searching for Emerging Moats

11 Jul, 2022 | Stock Insight

When it comes to investing, many know the value in identifying stocks with a big moat. Giants like Buffett and Munger maintain that this has been a crucial part of their success, but how can we identify one of these moats in the making?

In the wake of the ruins brought by World War 1, the French government vowed to protect its vulnerable northeast border with Germany from any future attacks. With horrid memories of fighting and living in open-air trenches, the French spent a decade building a 482-kilometre series of fortifications that would be both impenetrable and comfortable to live in.

The monumental concrete glory, known as the “Maginot Line”, included 142 large artillery forts, 352 fortified gun emplacements and 5,000 smaller bunkers (or pillboxes). Behind the imposing line of fixed defensive positions, tank traps and high concrete walls were fully equipped subterranean bases complete with mess halls, hospitals, recreation facilities and railway lines.

The Maginot Line was thought to be impenetrable and would prevent any WW1-style infantry and artillery attack. At the beginning of World War II, however, it wasn’t able to stop the Nazi war machine from quickly overwhelming and occupying France. The Germans quickly abandoned older tactics for a far more mobile and manoeuvrable attack that disrupted and dismantled the French defensive strategy.

The Oracle of Omaha: Warren Buffett

​For decades, Warren Buffett and Charlie Munger have taught all who will listen that a crucial ingredient to their investing success has been finding companies with a big “moat”.  An economic moat is the same concept as a moat around a mediaeval castle. It is about protection and long-term survival, preventing other businesses from stealing away a company’s profit margins or market share. Moats can come in different forms: network effects, real assets (e.g. property or infrastructure), intangible assets (such as brands or intellectual property), distribution, switching costs, price advantages and culture.

It’s not hard to see how a huge defensive wall around a business to protect it from competitors might create a very attractive investment. But by focusing only on the size of the moat, investors can miss the opportunity to invest in smaller businesses disrupting the status quo:  either globally, like Amazon (AMZN.NASDAQ) or Google (GOOG.NASDAQ), or locally, like REA Group (REA.ASX) or Jumbo Interactive (JIN.ASX). Competition is a potent force in capitalist societies, and mature businesses that once had seemingly “impenetrable” moats have been overrun by the forces of ‘creative destruction’ – think Kodak and Blockbuster.

Instead of focusing only on those mature companies with an existing moat, finding companies that are in the process of building their competitive advantage could be a boon to your portfolio. Beyond the clear-cut growth indicators like compounding revenue and increasing market share, here are some other barometers of an emerging moat:


Management reinvest capital into the business effectively

​Jeff Bezos once said:
“Friends congratulate me after a quarterly-earnings announcement and say, ‘Good job, great quarter.’ And I’ll say, ‘Thank you, but that quarter was baked three years ago.’”

​Amazon’s growth has been fuelled by continuous reinvestment into innovating and optimising its services. Many of its financial decisions are characterised by a preference for long-term growth instead of short-term profit chasing. Even as the company’s stock price continued to climb through the 2000s, Amazon was and continues to be known for spending big on what some investors considered bad bets, like branching into web hosting. The payoff has been a steep trajectory from a small moonshot company into a trillion dollar megacap.

Reinvestment usually comes in various forms, e.g. research and development; capital expenditure to increase capacity, enhance reliability or boost quality of product or service; and marketing to reinforce branding or gain larger mind share amongst customers. What’s important is to find a company that can continually reinvest funds and earn a high rate of return – the longer this runway, the better.

Destination focussed, avoiding the pursuit of short-term goals

Costco’s (COST.NASDAQ) retail concept is simple: customers pay an annual membership fee which provides entry to the stores for a year, and in exchange Costco operates an every-day-low-pricing strategy by marking up its goods significantly less than competitors (branded goods by only 14% and private label goods by 15%). By sticking to a standard mark-up, savings achieved through purchasing or scale are returned to the customer in the form of lower prices, which in turn encourages more consumers to sign up and buy more products, and extends the scale advantages. This is retail’s version of perpetual motion.

To appreciate the long term focus of building this flywheel, consider this story of Costco founder Jim Sinegal, recounted by well-known investor, Nick Sleep in 2002.

When the opportunity arose to take a higher gross margin than usual on a US$2 million shipment of designer jeans from an exporter (i.e. more than the standard 14%), Sinegal firmly insisted on refusing to break the contract with Costco’s customer, arguing with the exporter that if “I let you do it this time, you will do it again”.

Sticking to the long term destination focus of customer loyalty and footprint expansion has resulted in a 10x return on an investment in Costco from 2002 to today. The focus has firmed the brand, the stickiness of its suppliers and customers – an upward trajectory of its moat.

Alternatively, companies that either damage customer loyalty with operational pivots or reduce investment needs in order to boost short term profits are mortgaging their moats, especially if competition is spending heavily to take over its market share.

The Bottom Line

​There are very few companies that last a hundred years. It is vital to evaluate where a company is in the business life-cycle and the direction of its competitive advantage. Disruptive companies can have innovative technologies or operations that are more efficient and make the old way of doing business obsolete. These companies have the potential to change or entirely displace existing businesses and industries. Like David toppling Goliath, finding a wonderful business with a growing moat could provide outstanding returns.

Sign Up to Our Weekly Stock Insights

* Indicates required field

Name(Required)

Categories

Popular Topics