- By Dave Ahern
Finding a company with a strong competitive advantage like an Apple (AAPL) is what every investor is looking for. It is not easy and there are not a lot of formulas that you can use to find them. We are all on the lookout for companies with wide investment moats. Especially value investors. We love these types of companies. Companies with wide investment moats are likely to be around for a long time, not that they are invincible, but they are great companies for growing wealth over time.
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"But all the time, if you've got a wonderful castle, there are people out there who are going to try and attack it and take it away from you. And I want a castle that I can understand, but I want a castle with a moat around it." - Warren Buffett from a talk he gave to MBA students at the University of Florida
What is the definition of an investment moat?
A moat refers to "business' ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms." - Investopedia
Competitive advantage is going to be any factor that allows a company to provide a good or service that is essentially the same as it's competitors. But allowing them to beat their competitors in profits.
An example of this would be if you shop online for a product. Chances are you will see many different companies offering the same product but one stands out because it offers a lower price or perhaps free shipping.
This gives that company a competitive advantage over its competitors because of the free shipping that the others may not be able or willing to offer.
The example of free shipping would be temporary as the other companies would eventually start to offer that as well. But let's say your company develops a way to deliver them quicker and more cheaply. The other companies can't copy this method and that would lead to a bigger competitive advantage that would have some durability to it.
This is what we are looking for.
A company with the ability to create an advantage, other than price that others can't replicate or copy for themselves to cross that moat.
Warren Buffett on investment moats
Another quote from his talk with the MBA students from Florida.
"I like businesses I can understand. We'll start with that. That narrows it down about 90% [laughter]. There are all kinds of things I don't understand, but fortunately, there's enough I do understand. You got this big, wide world out there. Almost every company is publicly owned. You got all American business, practically, available to you. Now, to start with, it doesn't make sense to go with things you think you can['t] understand. But you can understand some things. I can understand this (picks up can of Coca-Cola [KO]). I mean you can understand this. Anybody can understand this. I mean this is a product that basically hasn't been changed much since 1886, and it's a simple business. It's not an easy business. I don't want a business that's easy for competitors. I want a business with a moat around it. I want a very valuable castle in the middle. And then I want the duke who's in charge of that castle to be honest and hard-working and able. And then I want a big moat around the castle, and that moat can be various things.
"The moat in a business like our auto insurance business at GEICO is low cost. I mean people have to buy auto insurance, so everybody's going to have one auto insurance policy per car, basically, or per driver. And I can't sell them 20, but they have to buy one. What are they going to buy it on? They're going to buy it based on service and cost. Most people will assume the service is fairly identical among companies, or close enough, so they're going to do it on cost so I gotta be the low-cost producer. That's my moat. To the extent my costs get further lower than the other guy, I've thrown a couple of sharks into the moat."
That pretty much sums up what Buffett thinks about moats and how he goes about looking for them.
His example of GEICO is one of the best examples out there. It is a product that everyone needs and is going to continue needing as long as they drive. And one of GEICO's calling cards is its pricing. They are often the lowest and not many can compete with that price.
This gives them their moat. Because who wants to pay more for insurance? Nobody! I know I sure don't. Most consider it a necessary evil.
Besides the pricing giving them an advantage over their competitors it also helps keep out other companies wishing to enter the market. GEICO can just lower the price to make it so unattractive to the other company that it won't even compete. Again a moat is created with this barrier to entry.
Another concept that Buffett refers to is a promise or a share of mind. By this, he is referring to a given brand and the promise of quality a consumer can expect from that brand.
It's all about trust and reputation. Think of Coke. When you open that bottle you know exactly what you are going to get every time. You trust the quality and taste. This gives consumers confidence and reduces their risk of spending money for something they won't like.
And for Coke, it gives it branding power, which can enable it to raise prices because people will often pay more for a brand they know and trust as opposed to an unknown or unfamiliar brand that is cheaper.
This is also great for Coke because the branding helps with creating customers who will keep coming back for the product which helps create predictable and steady cash flows.
Charlie Munger on investment moats
"The difference between a good business and a bad business it is that good businesses throw up one easy decision after another. The bad businesses throw up painful decisions time after time." - Charlie Munger
Munger feels so strongly about moats that he has included it as one of his famous "four essential filters" for locating great businesses to invest in.
Buffett and Munger have both said that they prefer to find great moats and buy them as opposed to trying to create them. They feel it is easier that way, and they feel they are better at locating them than creating them.
At the 2012 Berkshire meeting, Munger said:
"We buy barriers. Building them is tough. Our great brands aren't anything we've created. We've bought them. If you're buying something at a huge discount to its replacement value and it is hard to replace, you have a big advantage. One competitor is enough to ruin a business running on small margins."
For example, he believes that you don't need to make hamburgers to see that McDonald's (MCD) has a moat. But don't dream of building a burger joint to compete with them without someone like Ray Kroc running the show.
Munger believes that the creative genius and management of these companies is just as important as the product or service sold. He gives examples of Kroc, Sam Walton, Bill Gates (Trades, Portfolio) and Estee Lauder (EL) as examples of great leaders as well as visionaries.
Five types of moats
Type 1: Supply side economies of scale
An example of this would be Walmart (WMT). It has made significant investments in its distribution systems and online systems. It also has a huge degree of operational effectiveness.
Think of Sam's Club or Costco (COST) with their massive buying power that allows them to sell the same items at a much lower cost, which smaller competitors can't compete against. The profit margins are there for Costco.
These moats are based on the size of the company and its ability to outsize the competition in areas of operational efficiency, buying power or ability to dominate the market to the point that it becomes the market.
Type 2: Network effects
Simply, this is a result of a product or service becoming more popular as more people use it.
A great example of this would be Google. It has two extremely monstrous network effects with the Google Search and Google Ads.
Google is so popular that it has become a verb. To Google it. Think about it. We all say we are going to Google something, as opposed to looking up the information. It has become so entwined in our culture that we all know what it means to Google something.
Another example would be American Express (AXP) because the more merchants accept the card the more valuable the service gets and the more people who use the card the more valuable the services is for merchants.
Type 3: Brand
This is probably the easiest and most recognizable moat there is. Most people can pick out a brand moat.
The power of a brand moat comes into play when a company can raise it's prices and no one cares. Think about Disney and the price of going to one of its parks. It is not cheap, but it is an experience one will never forget so you pay the price because you want that experience that you can't get anywhere else.
This is the power of a brand.
Type 4: Switching costs
Products and services that are not easily abandoned for a substitute or a competitor's product.
Several examples that spring to mind would be Apple. Once you are a part of its ecosystem it is very hard to leave for Android, for example. Once you have the iPhone or a Mac, it is hard to go back to Windows or Android.
There may be aspects of Android you might like, but the cost in time and money makes it prohibitive to switch.
Another example would be your bank. Switching your bank accounts is a royal pain in the butt. With automatic payments for everything now it is very labor intensive to switch banks. They also have incorporated newer technologies that make switching to another bank obsolete. For example, the online experience at Wells Fargo (WFC) is completely different from Bank of America. Because Wells is a leading competitor in that field it makes it that much harder to leave them for Bank of America (BAC).
Type 5: Patents and intellectual property
Companies granted patents are given a legal monopoly for as long as that patent exists. No other company can utilize that formula or product until the patent expires.
An example of this would be Qualcomm (QCOM). It has so many patents and has managed to get them embedded inside enough important wireless industry standards that the company has created a substantial moat.
Another example would be pharmaceutical drugs for which they get patents. Once they achieve that status and the drug finds a niche for the disease it is treating, that company will enjoy a monopoly until that patent expires. This is where the money becomes great for these drug companies.
Two easy ways to find investment moats
Now that we know what a moat is and what the different types are, it is time to discover the different ways to find an investment moat.
Return on invested capital
First, let's look at what return on invested capital is. According to investinganswers.com:
"Return on invested capital (ROIC) is a profitability ratio. It measures the return that an investment generates for those who have provided capital, i.e., bondholders and stockholders. ROIC tells us how good a company is at turning capital into profits."
What this tells us is that it shows how good a company is allocating its capital, whether that is reinvestment in the company, capital projects to increase assets or simply being good investors.
Why would we use this formula to help us find an investment moat? Simply because it shows a company that is really good at creating assets for its shareholders. Or because it doesn't have a lot of competition, and thus the need to reinvest its own capital instead of creating more assets to increase its capital.
To find the ROIC for a company the easiest way is to look at your favorite finance site. I will use Morningstar.com today. Very soon I will go over in depth how to calculate this ratio on our own. But for now to get us in the ballpark, we will use the information from Morningstar
Let's look at some companies and then compare the ROIC to see how to determine a wide moat.
All numbers will be from TTM or the trailing-12-month period
National Oilwell Varco (NOV)
Johnson & Johnson (JNJ)
General Electric (GE)
So that is a pretty diverse list with some really big market caps, like Amazon, Apple, and Microsoft (MSFT). And a few smaller ones like Gamestop (GME) and National Oilwell Varco (NOV).
We are looking for any numbers that are going to be in excess of 15%. This would indicate that a company has a strong moat, especially if you see that number for a number of years.
Another factor would be to compare this number to the company's cost of capital. This would indicate whether it was creating value or not. We will go into that in much more detail when we break down the ROIC formula.
For now we will use this number as a guide to tell us that we need to look further to investigate whether it has a moat. Again this number alone is not a valid reason to invest in any company you find. Our job is to do a total investigation and find reasons not to buy the company. If we go into it with that attitude we can be more rational about our decision.
As opposed to falling in love with the company and justifying our reasons based on a few good numbers.
A few numbers that jump out at me were General Electric (GE) and Amazon. Both have huge market caps and are household names, but according to these numbers that wouldn't have a moat. Now in GE's case, it has been floundering for a few years now and I am not surprised. But Amazon was a surprise and would merit a closer look at the numbers to see if this was just a one-off number or if this was an indication that maybe Amazon doesn't reinvest its capital efficiently. Or perhaps it is not a shareholder-friendly company and is only concerned with growth at this point.
No one would reasonably say that Amazon isn't a great company and hasn't changed the world in many ways. But our focus is finding a moat, and this indicates it does not have one at this time.
So what are dividend aristocrats?
According to Sure Dividend , they are:
"The Dividend Aristocrats are a select group of 51 Standard & Poor's 500 stocks with 25-plus years of consecutive dividend increases.
"They are the 'best of the best' dividend growth stocks. The Dividend Aristocrats have a long history of outperforming the market.
"The requirements to be a Dividend Aristocrat are:
- Be in the Standard & Poor's 500.
- Have 25-plus consecutive years of dividend increases.
- Meet certain minimum size and liquidity requirements."
If you'd like a list of the Aristocrats you can find it here.
The reason this would be a way to find a company with a strong investment moat would be pretty simple. If you have the financial strength to pay a rising dividend continuously for 25 years or more, that would be an awesome indication that you had an extremely durable competitive advantage.
In other words a very strong moat with a strong competitive advantage. When you look at the names of the companies that make up this list you will find some very recognizable brand names. Such as Coca-Cola, Johnson & Johnson (JNJ), Walmart, Pepsico (PEP), Colgate-Palmolive (CL), AT&T (T) and on and on.
I won't go over the whole list, but just reading through those names above gives you a pretty good idea that these companies have a strong competitive advantage and are very strong financially - all characteristics of a company with a wide investment moat.
Another perk in buying any of these companies would be that they are incredibly shareholder friendly. The reason I say this is the fact that they have grown their dividends payouts for over 2 1/2 decades and in some cases more than five decades.
This is the type of performance that is indicative of their importance in giving back to their shareholders, in this case in the form of dividend payments.
In addition to the dividend, the Aristocrats have performed remarkably well over the last decade, compared to the S&P 500 they have grown at 9.63%, while the S&P has come in around 6.99%. This is an outperformance of 2.64%, which is amazing.
Of course, investing in Dividend Aristocrats is not fool proof, and you have to do your research to ensure that these companies meet your other requirements for investing in them. Beware that they may be overpriced compared to their intrinsic value so it is important to do your due diligence before investing. Use our formula that we investigated earlier to determine a fair price before investing.
We have discussed many different aspects of moats and how to find them. The importance of finding a company with a wide investment moat cannot be understated.
This discovery can help you in so many ways. Great companies with these types of moats can sustain their earnings for decades as well as continue to grow their dividends. All of these factors help grow our wealth over time and are crucial to our investing health.
There are no guarantees in investing, and you always have to keep that in mind when you are considering any investment. Just because the numbers line up doesn't necessarily indicate that you have a true moat.
Sometimes it is just a matter of the sniff test. If it smells like a moat, then it probably is. Take Coke, for example. It is such an indelible part of our society at this point and time, but with the winds of change in people's health choices, it has chosen to start buying juice companies, water companies, and others to start diversifying its portfolio of offerings to appeal to those tastes.
This is incredibly smart to try to adapt, and this is one of the ideas that makes it great.
Another thought to keep in mind when you are searching for a wind investment moat is the valuation of that moat. Just because you discover one, it doesn't mean you should buy into it at any price.
The price has to make sense, too. Discovering the intrinsic value so you have a margin of safety is what helps preserve your capital.
And it can make you a ton of money too.
Follow the steps we discussed in today's article and you will be farther along in discovering great companies to invest in. And you these discoveries will help you grow your wealth for decades.
And for the younger crowd that is reading this, that is vital to your wealth building.
That is going to do it for this week.
As always, thank you for taking the time to read this post. Let me know what you think of this article in the comments. I would love to hear your thoughts on finding moats. Do you have any ways that you would share?
Disclosure: The author doesn't hold any positions in the stocks listed.
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This article first appeared on GuruFocus.
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