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.
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:
- 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.
- 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.
- 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.
- 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:
- 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.
- 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.
- 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.
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