The Vision To See Economic Moats

Chip Maloney Blog, Educational 17 Comments

Nearly two decades ago when I was in my early 20’s, I fell into the role of director of our local service club’s community service committee. Within this role, I was tasked with the oversight of the building of a day-use park in our community. The first time I visited what would be the future site of our park was with our club president.  The city had assigned us a piece of land that was located on top of a former landfill.  Let’s just say that I had a difficult time imagining that one day in the not too distant future, families would be enjoying their Sunday afternoons chasing their kids around a park that would be built on this piece of barren land that was a former garbage dump.  However, our club president, who I considered a mentor, started to tell me about his vision for the land.  He pointed out where he envisioned the playground would be, complete with swings, a play structure and benches for grandparents to watch their grandchildren play.  We walked over to the area where the barbecues and picnic tables would be located.  He described where the restrooms would be in case little Timmy suddenly found himself with a full bladder.  He pointed out where trees would be planted to provide shade for families from the afternoon sun for many years to come.  Not only did he have a vision of what he wanted for this park, he had a way of getting the rest of the club members to adopt his vision.  In the years that unfolded, the park was built and today families enjoy this park almost exactly as our club president had envisioned it many years earlier.  That experience taught me how powerful having a vision can be if you act on it in a meaningful way.

In his book “100 to 1 in the Stock Market”, author Thomas Phelps emphasizes the importance of vision in stock selection. He writes that to make money in stocks you must have “the vision to see them, the courage to buy them and the patience to hold them”.  Vision can be an important tool in an investor’s toolbox, and it is a skill that can be learned.

At the heart of it, vision is the ability to anticipate what the future could look like.  As an investor, in order to figure out what to pay for a company’s stock today, you really need to attempt to estimate the company’s value some years into the future. Vision involves looking into the future and assessing the fundamental factors that will influence revenues, earnings and cash flows that will determine a company’s potential value a number of years out.

Trying to predict an accurate future for some companies in ultra-competitive industries can be like looking through a fog at midnight and can be very difficult. Yet for other companies, visualizing the future can be like looking down from a mountain on a sunny day with no clouds – the view into the future can look pretty clear. These companies where you can predict the future with a higher degree of certainty tend to fall into a small group of companies that possess an economic moat.

I first read about economic moats many years ago in the Berkshire Hathaway Letters to Shareholders written by Warren Buffett.  An economic moat, according to Buffett, is a durable competitive advantage that a company possesses that protects its high returns on invested capital from being eaten away by competitors. The best economic moats around a business are similar to moats around a castle – they provide strong barriers to prevent its enemies (competitors) from crossing the moat to destroy the economic castle.

moat

Pat Dorsey in his excellent book “The Little Book that Builds Wealth” lays out a framework for identifying economic moats. Based on the research he did on moats while he was the head of research at Morningstar, the following are the four most common categories of economic moats he and his team identified:

  1. Intangible assets:  Companies with this type of moat often have a strong brand, license or patent that allows them to sell products or services that cannot be matched by competitors.  A strong brand increases a consumer’s willingness to pay because it gives them a consistent or aspirational experience (think Heinz Ketchup or Tiffany diamonds) or lowers a consumer’s search costs (think Amazon which saves a consumer time and/or money because they trust Amazon has the lowest prices).  A company may also hold a license to operate a virtual monopoly like companies within the landfill industry – it is safe to say that most municipalities are not granting any more licenses to operate garbage dumps within city limits. Companies may hold a patent or better yet, a series of patents, as in the pharmaceutical industry.  These intangible assets create a durable competitive advantage that prevents the competition from making inroads into these companies’ niche.
  2. Network effect:  Some businesses have moats that rely on a network of customers, where each customer added to the existing network makes the network more and more valuable.  The most valuable network-based products or services are the ones that attract the most users. This creates momentum that squeezes out smaller networks and increases the size of the largest networks in a winner-take-all phenomenon. Companies like Facebook, Ebay and Visa and Mastercard all benefit from the network effect.
  3. Switching costs:  Companies that make it tough for customers to switch over to use a competitor’s product or service have an economic moat because their customers rarely leave them.  You find switching costs when the benefit of changing from company A’s product to company B’s product is less than the cost of doing so. The software industry is one of the biggest beneficiaries of switching costs.  Because software is often mission critical, and tightly integrated with a company’s business processes, in order to switch to using a competitor’s product it would require not only monetary costs, but retraining costs and lost productivity for a period of time. There is a reason that the software industry has had many of the best performing companies over a long period of time.
  4. Cost advantages:  Cheaper processes, better locations, greater scale, or access to a unique low-cost resource allows a company to offer a product or service at a lower cost than its competitors.   Cost advantages are most important when price is a large portion of a customer’s purchasing criteria. Gravel quarries benefit from this moat because the cost to transport their product is high compared to the cost of the physical product. This results in the quarries closest to busy economic centres having a location-based cost advantage. Another example of a cost advantage is a commodity-based company like an oil and gas producer that has access to a world-class resource that benefits from low extraction costs. Even if commodity prices become depressed, these low-cost producers often continue to mint money, and in good times, they tend to gush cash. In addition, large manufacturing companies and companies with distribution networks tend to have scale-based cost advantages. These companies are often able to spread fixed costs over a larger volume of products or services delivered.

The majority of small companies have little to no economic moat around them.  In these cases it is pretty easy for upstart competitors to start competing against these companies as there are often few barriers to enter the industry which allows them to steal market share from incumbents. These companies are often situated in industries that are so competitive that it is often impossible to determine what the future holds because industry economics can change rapidly.  Developing a vision for these companies’ futures will often prove highly inaccurate.

A much smaller percentage of small companies possess one or more of the economic moats discussed above which prevents new and existing competitors from attacking their businesses.  With these companies you can develop a vision of the future with much more certainty of accuracy because you can see beyond the near term that their economic moat will be enduring. This should allow them to continue to generate good returns on invested capital due to the protections offered by the economic moat.

Some of my biggest investing mistakes over the years have come from investing in companies lacking an economic moat where my vision of the companies’ future turned out to be totally wrong and resulted in disastrous investment results. However, one past investment I made where I got it right demonstrates the value of identifying a company with a strong economic moat and having a vision for where the company could be a few years out. The microcap company was called Century II Holdings, and its sole division was a niche document and package delivery company called ICS Courier.

I bought my first shares in Century II in late 2004 at $.85 per share after a friend introduced the idea to me when the company was still unprofitable. The courier division had been mis-managed, but the company had hired a new CEO who had been on the job for seven months to turn around the business. After selling the telecommunications division, it now had over $1 of net cash per share and a renewed focus on the ICS division. It was the fact that the stock price was selling below the net cash in the company that initially attracted me. However, not even factoring in the net cash on the balance sheet, this company was trading at a valuation of 12% of revenues, so there was a large margin of safety even if the turnaround failed.

Shortly after I made my initial investment, I was fortunate to spend some time with the branch manager of one of the local distribution centers who had many years of experience in the transportation industry and who gave me unique insights into ICS. She told me about the new CEO, and how he had turned around other businesses that were in worse shape than ICS. She shared with me how the new CEO had visited every facility in Canada within his first six months on the job and had already met almost every single employee in the company. She relayed to me how the management structure had been flattened to pull out unnecessary expenses and how the new CEO had re-invested those savings into IT and facility upgrades, investing in customer service that had been lacking prior, and adding routes where needed. She explained how the recent small acquisition that he had made had increased their market share even further in the optical industry. She helped me understand that this was a growth business, that a renewed focus on increasing the higher margin Next Day delivery service should lead to growth over the medium to long term. But most importantly, she shared with me what she felt were the competitive advantages or moats that ICS benefitted from that would protect the business from competitors as the turnaround took hold, and could result in decent rates of return on capital once the business was turned around. I learned that ICS had the following economic moats:

  1. Network Effect: Although she did not call it the network effect, nor did she even use the word network, she helped me understand that ICS had a very strong distribution system within a number of niche industries, resulting in a high market share in the insurance, financial services, dental, and optical industry niches. In optical, for example, ICS delivered packages of eyeglasses from optical labs to optician clinics and eyewear stores. The connections within the distribution network were solely between the optical labs and the optician clinics, which resulted in a hub-and-spoke network. Hub and spoke networks are not as strong as interactive networks where there are connections between all the users. Nonetheless, ICS still benefitted from the network effect as they had more than 90% market share in this industry and every additional eyeglass store they added to the network strengthened the value of the network because it made the delivery routes even more dense and profitable. It would have taken a competitor a significant amount of capital and years of operating losses to try to penetrate ICS’ moat because of the strength of its distribution network in each of it’s niches.
  2. Switching costs: Because its customers dealt in such high volumes, ICS had fixed routes where the drivers would visit every customer in the network every single day. So the customer was guaranteed that their package or document would be picked up without having to call for a pick-up. This saved customers time, and having one of the larger competitors doing this would have increased the amount of time a customer would have to deal with arranging for package pickup. In addition, ICS had less handling and conveyor belting than the larger competitors which, in turn, lead to less damage of documents and packages.
  3. Cost advantage: ICS could undercut the other document and package delivery companies like Purolator, Fedex, UPS, and Canada Post because its delivery routes were so dense and high volume. The cost to delivery or pick-up an incremental document or small package was very small when the driver was already doing a pickup or delivery at a location, which they visited every single day. ICS would have had trouble competing in most industries outside of its niches, but within its niches ICS was significantly cheaper than larger competitors due to greater economies of scale, and competitors could not match them on price.

In hindsight, I don’t think I had a full appreciation for the strength of the economic moat that this business possessed. But it seemed that everything the new CEO was doing was with the goal of improving the moat that they already had. With the insights I learned about the business and especially it’s economic moat, I was able to develop a rough vision for what the company’s economic fundamentals might look like two or three years out.   By the first quarter of 2005, the turnaround started to manifest itself in the financial results as margins began to improve. With my knowledge and confidence in the ICS moat, I gained the conviction to hold, and the confidence to average up on my position a few times at higher prices along the way. Ultimately, Century II went from losing 16 cents per share in 2004 to a run-rate of 80 cents EPS before it was acquired by a competitor in late 2007. In the end, the stock price went from 85 cents per share in late 2004 to $10.20 less than three years later.

Hopefully, you now have a better understanding of how analyzing economic moats can improve your vision. Even though it was a turnaround, the case of Century II required an investor to have a vision of the future, and along with other factors, identification of the economic moat helped to improve the accuracy of that vision once the moat was harnessed by a competent manager.

Obviously the future is always uncertain, but you do not have to be Nostradamus to see the future potential of small companies if you have a good understanding of economic moats. If you can identify a business with a durable economic moat, and if you can have the vision to see that the moat will continue to produce business success in the future, as long as the company is being run by able management and you pay a reasonable valuation, that combination will more often than not lead to successful investment returns. I just hope you won’t have to build a park on top of an old landfill to learn the lesson that I learned about vision.

MicroCapClub is an exclusive forum for experienced microcap investors focused on microcap companies (sub $300m market cap) trading on United States and Canadian markets. MicroCapClub was created to be a platform for experienced microcap investors to share and discuss stock ideas. MicroCapClub’s mission is to foster the highest quality microcap investor Community, produce Educational content for investors, and promote better Leadership in the microcap arena. If you are a passionate microcap investor, Join Us.

About the Author

Chip Maloney

Chip Maloney is a Canadian-based private investor and has been investing primarily in non-resource Canadian microcaps for 15 years. His investment style could be summed up as GULP (Growth at an Ultra Low Price). When he is not doing investment-related reading, you can find him running, biking, skiing or spending time with his wife and daughter.

Comments 17

  1. Another superb article Chip! It infuriates me that I still make lots of Economic Moat errors.

    In your article I believe you did a particularly good job of identifying what I label as “Type II” Econ Moat errors (The Firm with the economic moat NOT being properly labeled as moat-tastic due to lack of vision, knowledge, proper category identification). One can sacrifice a lot of potential profit because of Type II mistakes. I’m glad your interaction with the branch manager in your example gave you the insight to glean the true economic moat of ICS.

    Where a lot of experienced investors including myself lose money (and not just potential gain) is when we commit a Type I Econ Moat error (The Firm without a true economic moat misidentified as moat-tastic.) My Type I mistakes come in two flavors generally: a) I like the business and management but confuse temporary strong results with a more permanent advantage; and b) since I know great firms have economic moats and since I spent so much time researching this company … maybe it does have a moat. Falling for the Jedi Moat Trick.

    One is supposed to believe when they see it (the vision to see economic moats) but I too often see it because I believe it. “The Vision NOT to See Economic Moats.” Not as catchy a title I admit.

    1. Great comment EightTrack and thanks for stretching my thinking on this subject. I am impressed with your reference to Type I and Type II hypothesis errors.

      I have certainly made these Type II errors too. One example is an investment in a company called Fortress Paper. Fortress made a business model transformation into the dissolving pulp business about four years ago, and touted their future mill as a low cost producer once it was retrofitted and complete with a state of the art biomass cogeneration facility that would lower costs even further. Management, who had a fantastic track record for creating value up to that point, touted the future mill as being around the lowest quartile of the cost curve (around the 25th percentile), once complete. However, here we are four years later, they have burned through several hundred million dollars in operating losses bringing the mill on stream and they still have not hit the 25th percentile in terms of costs. They are now getting close to that first quartile cost curve position.

      I learned on this investment that management is not a moat, and there is a big difference between being the low-cost producer and being a low-ish cost producer. The Brazilian dissolving pulp producers (who do have an economic moat) have a major cost advantage because they have access to very cheap feedstock for their mills with the much faster growing Eucalyptus tree where the trees mature in almost half the time as they do in Canada. This gives them a $200-$300/tonne advantage over competitors like Fortress, which is significant on a product that currently sells for $850/tonne. The other lesson I learned is that in a commodity business, when there is an irrational industry player (Chinese mills) that controls 1/5 of the industry capacity, you better be the absolute lowest cost provider, because industry prices can stay well below the marginal cost of production as these irrational producers continue to dump production onto the market even though they are high cost producers losing gobs of cash.

      The jury is still out on Fortress Paper as an investment from here, as they are through the worst of it, but ultimately, this was an error in my analysis and costly.

      1. I continue to be astonished at the breadth of your knowledge. From self-storage rental rates in Warsaw for ladies of the night to Eucalyptus tree growth rates in South America. Thanks for the extensive reply.

  2. Yes, moats, important. It took me a long time, many years, to recognize how important. Instead I screwed around with bankrupt bonds and poorly run companies with lots of cash and real estate. That fine, and interesting, but what works is compounding and compounding only works in companies with a competitive advantage.

    Putting aside Amazon, which is a special case, competitive advantage appears as financial performance. Which leads me to the second hard lesson I’ve learned — investing in companies that you think will have a moat tomorrow or next week or next year is much riskier than investing in one where the moat is established, in which case it will show up primarily in return on capital and secondarily in gross profit (trend not margin). And return on capital is a function of capital turnover (sales divided by assets) and margins. Competitive advantage generally means cost advantage (economies of scale over competitors) or special value over to customers that competitors can’t match (higher margins).

    The question I haven’t yet figured out is the importance of this question — Do you know where the company will be versus its competitors in ten years? Buffett points to Wrigleys and Coke — in 10 years, he knows where they will be. Coke isn’t particularly concerned about RC Cola. But the highest margins, and sometimes the highest capital turnover, is often found in leading companies in rapidly evolving markets, where it is difficult to see ten years ahead. Not investing in those companies penalizes performance I think.

    And then there is the issue of growing dividends. A 3% dividend that grows at 5% a year becomes huge in 20 years. I haven’t done the numbers but would guess an annual return on the initial purchase price of 40% or more, before any stock appreciation. That dividend growth has been responsible for much of Buffett’s success.

    Anyway, some supportive comments in response to your interesting piece. Thanks Chip.

  3. Great comments Rod. I think your point about highest margins and returns on capital coming from companies in rapidly evolving industries is spot on. They tend to get some of the highest multiples and investment returns, at least for the period where they do have a competitive advantage. However if a company is worth all the future cash flows discounted back to the present, many of these companies should be worth much less than a company like Coke that has a more durable competitive advantage. I think all one can do is invest based on these principles, and let the speculators invest in these other plays with less durable moats.

    I would also argue that durable competitive advantages/moats are more rare than they used to be and on average competitive advantage periods are shorter than they used to be. With disruptive forces like the internet, offshore manufacturing to low-cost countries etc., moats are much more fleeting. To use the software industry as an example, the shift to internet-based SaaS business models in some ways has decreased the moats around these software businesses compared to traditional on-premise software models. The barriers for a customer to leave are moderately lower for software customers of SaaS businesses now because you don’t have the lock-in from the sunk costs of the initial license payment that deter customers from switching and the model itself has resulted in a net deterioration in operating cash flows due to less of these upfront payments.

    Here is an exchange between Warren Buffett and Bill Gates from 1998 where Gates states that tech companies should in fact trade at lower multiples. Who am I to argue with Bill?

    BUFFETT: I didn’t grasp it at first, but it’s huge. The technological revolution will change the world in dramatic ways, and quickly. Ironically, however, our approach to dealing with that is just the opposite of Bill’s. I look for businesses in which I think I can predict what they’re going to look like in ten or 15 or 20 years. That means businesses that will look more or less as they do today, except that they’ll be larger and doing more business internationally.
    So I focus on an absence of change. When I look at the Internet, for example, I try and figure out how an industry or a company can be hurt or changed by it, and then I avoid it. That doesn’t mean I don’t think there’s a lot of money to be made from that change, I just don’t think I’m the one to make a lot of money out of it.
    Take Wrigley’s chewing gum. I don’t think the Internet is going to change how people are going to chew gum. Bill probably does. I don’t think it’s going to change the fact that Coke will be the drink of preference and will gain in per capita consumption around the world; I don’t think it will change whether people shave or how they shave. So we are looking for the very predictable, and you won’t find the very predictable in what Bill does. As a member of society, I applaud what he is doing, but as an investor, I keep a wary eye on it.
    GATES: This is an area where I agree strongly with Warren. I think the multiples of technology stocks should be quite a bit lower than the multiples of stocks like Coke and Gillette, because we are subject to complete changes in the rules. I know very well that in the next ten years, if Microsoft is still a leader, we will have had to weather at least three crises.

    http://archive.fortune.com/magazines/fortune/fortune_archive/1998/07/20/245683/index.htm

    1. Fascinating interview excerpt Chip.

      I think though I’d rather have been an investor in Microsoft or Apple than in Coke or Wrigleys over the last twenty or thirty years. The issue then, at least in my mind (not obviously in Buffett’s) is given that the market won’t shut down for ten years, at least without a complete and udder collapse of the financial system, is an investor nimble enough to make a decision once a year — is the company (say Microsoft or Apple) still a leader? If yes, I think that Apple or Microsoft is likely a better investment than Wrigley’s or Coke. If no, if like Buffett says he wants to invest in companies that if the market shut down for ten years, will still be wonderful stocks, those dominant consumer stocks are the way to go.

      Buffett had major exposure to newspapers for twenty years on the theory that their moat was impenetrable. Now he has a major position in Bank of America (I think but also wonder if I read somewhere recently he’s sold that) — in fact today Bank of America is just as dependent on technology as Microsoft. So there’s some contradictions there.

      But the question of durable competitive advantage is, I think, crucial investment strategy, and worth pondering.

      Ben Graham rejected IBM as an investment, and wrote extensively on that subject — I think if I remember correctly in the 1978 edition of Security Analysis. Mostly, his retrospective thoughts were that he was wrong to reject the company as an investment and out of that came his essays on valuing growth companies which are truly fascinating.

  4. Interesting comments Rod. Buffett seems to value certainty of returns over almost everything else, hence why he is willing to take maybe lower returns for an almost guaranteed return in these moated consumer products companies. In the clip linked to below, of Buffett’s biographer Alice Schroeder, speaking about Buffett’s investment process, she says the first step in his thought process when looking at a company is “what are the odds that this company could be subject to catastrophe risk”. If he perceives any risk of a permanent impairment of his capital, he just won’t invest, no matter what the reward I find this comment ironic because Berkshire sells catastophe insurance where they take infrequent but large losses on underwritten policies. But I understand that they spread the risk over many different insurance policies. Surprised he is not willing to take this basket approach when buying common stocks that have high reward potential but some small risk of being a zero.

    https://m.youtube.com/watch?v=KwAkiVUnKx0

    Do you remember where Graham published his essays on valuing growth companies? I would be really interested to read those.

    1. Hi Chip. I just looked up the essay “Newer Methods for Valuing Growth Stocks” by B. Graham, which appeared in every edition of SECURITY ANALYSIS from 1962 to 2009. The essay includes this excerpt

      “We know, of course, that where high growth rates have been continued over long periods, investors have fared very well in such shares, even though they paid what seemed to be a very high multiplier of current earnings at the time. The outstanding example of such experiences is International Business Machines. Its apparent high selling prices in the past have always turned out to be low in the light of subsequent growth of earnings and subsequent price advances. The 1961 multiplier of, say, 80 times current earnings could also prove to be an undervaluation if the rate of past growth is maintained sufficiently long in the future. . . ”

      The entire chapter also appears in the book “Benjamin Graham And The Power of Growth Stocks” by Frederick K. Martin. I can send you a book review of that book that includes other excerpts if you would like.

  5. Superb Article! 🙂

    Being a newbie, I am trying hard to get new perspective to develop an ability to have vision to see the future of microcaps.

    This writeup ofcourse helped me to gain wisdom on this journey.

    Followed you on Twitter.

    It was an awesome read, Thanks.

  6. Great stuff Rod. I have the first, second and fifth editions of Security Analysis and I looked through my 5th Edition published in 1988 for the essay and it is not in there. I think that the fifth edition is the worst edition – I looked in the index and Ben Graham is only referenced on five pages in the entire book. I will try to track down a copy of the fourth or sixth edition.

    I am really interested in the Frederick Martin book. I will pm you on MCC.

    Thanks.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.