10 Lessons on Moats

Capital Allocation, Compounder, Moat, Strategy / Thursday, July 25th, 2019

Moat is independent of market size

The common misunderstanding for moat like scale economies is that it only exist in large markets. While a company has to reach a certain size to achieve scale advantage, it is in relative to the size of its competitors, not the size of the market. A company that is 5 times larger than its second competitor has a scale advantage regardless of its size relative to the entire market. And most of the time, it is easier to achieve scale economies in small markets than a global market. Just as a small town can only fit one newspaper firm, it is easier to achieve scale economies and defend that advantage in a smaller market because other competitors have to gain a substantial market share gain to achieve minimum efficient scale (MES). In contrast, in a global market, each competitor only needs a small gain in market share to achieve MES. Therefore, making it harder for any incumbent to have a superior advantage over the other.

Moat is dynamic

Moat is not static; it either strengthen or weaken a little every day. It is important to study how a company allocates its capital to understand how that affects the size and strength of its moat. So the question is not whether a company has a moat. But whether the company is growing it. A company that has no moat but is in the progress of building one will be far more attractive than a company with a strong but shrinking moat. 

Moat can be long-term negative

Not all types of moats are good for customers. Take the switching cost. Some companies exploit their pricing power by constantly increasing the selling price to the long-term detrimental effect of their clients’ business. Why should you care? Because it is better to own a company that creates abundance through win-win situations. Companies that engage in ‘I win you lose’ situations could one day end up getting the short end of the stick.

Another situation why moat might become long-term negative is complacency. The analogy of a moat is a castle surrounded by a deep broad ditch that makes it hard for enemies to plot an attack. It works the other way round as well. Moat makes it difficult for the rest to exit just as it makes it hard for the enemies to enter. It can be an asset that fortifies a company. Or it can be a liability that encumbers the company.

Moat companies can be mispriced

While quality companies tend to sell at a bargain in a crisis, some of these companies can remain mispriced even under normal economic conditions. This is especially true for moat companies that are considered boring. These companies tend to grow at a consistent 8-10% annually, while selling at around 20 P/E with a large total addressable market. They tend to get dismissed as a potential buy because they always look fairly valued—high multiples with a decent growth rate. However, the market return for these compounders is not boring by any means. 

Consider Fastenal, the largest fastener distributor in North America. Fastenal has grown its revenue at 9.5% per year over the last 10 years. Decent if not terrific compared to the likes of Amazon or Apple. Also, it was selling at 28 P/E in 2009. A multiple that would give most investors a pause. Despite that, it has recorded a 35% CAGR (capital gains + dividends) over that period. Or consider a stock closer to my home, LPI Capital, a general insurance company in Malaysia. LPI Capital’s 9.6% revenue growth rate and a median P/E of 18 over the past 10 years are not a screaming buy. But the stock has returned over 300% during that period before any dividends. 

The length matters more than the spread

The spread is the difference between the capital return and the capital cost. Whereas the length is the period the company can maintain that spread. While the capital return is always the higher the better i.e 25% is better than 15%, what’s more important is how the normalized capital return will look like over the next 10-20 years. It is far better to own a company that can earn a 15% normalized capital return over the next 10 years than one that has a short burst of 25% capital return for 2-3 years before reverting to 10%. Stocks with this kind of short burst are almost always overpriced (and a trap) because the market expectation is at its highest right before the capital return collapse.

Durability is the evidence of a moat

It is easy to get confused that a company must have a moat if it is growing fast. But high growth doesn’t cause moat just as moat doesn’t cause high growth. Growth can happen for many reasons from supply constraint, industry tailwind to a sudden pickup in demand. All of which are the ebb and flow of the business cycle. Rather, the evidence of a moat comes from the ability to defend abnormal return. When assessing if there is a moat, the important questions to ask are “Is there anything that prevents others from doing what the company is doing?” and “Can you kill the business if you have an unlimited amount of capital?”

Growth stage determine the moat

Certain moats only manifest itself at a particular growth stage of a company. Of the 7 moats, counter-positioning and cornered resources generally show up in the early stages of a company. Once a company enters the growth takeoff stage, moats like network effect, switching cost, or scale economies would take a prominent role. On the stability stage, branding moat and process power moat takes over. 

It is essential to understand the characteristics of a moat to avoid finding one when there is none. For example, companies that are less than 10 years old generally don’t have brand power. A powerful brand typically takes 20 years or even longer (i.e liquor brands) to build. When trying to identify a moat, you have to determine the company’s growth stage and tie it with the type of moats that are likely to appear.

Capital allocation affects moat

The two roles of every management team are to manage the business and allocate capital. How does the management allocate capital—dividend, M&A, capital expenditures, working capital, buyback, etc— has great implication on the moat. As Warren Buffett wrote, “After ten years in the job, a CEO whose company retains earnings equal to 10% of net worth, will have been responsible for the deployment of more than 60% of all the capital at work in the business.” Having a good grasp of business strategy is indispensable.

Netflix is a case in point when they shifted their business model from DVD rental by-mail to online streaming. Another pivotal point was when Netflix decides to produce original content to reduce reliance on licensing. Both capital allocation decisions dramatically strengthen their moat. 

Capital return, reinvestment opportunity and durability period

These are the 3 things that determine how much to pay for a moat. Capital return assesses what’s the long-term incremental return; reinvestment opportunity assesses what’s the total addressable market, and durability period assesses how long can the abnormal incremental return be maintained. 

Among all the moat companies, the best kind is ones that can deploy a majority of capital and compound incremental return at a very high rate for a long time. But this type of companies is rare. The more common ones are those that have a high historical capital return but has little reinvestment opportunity either because reinvestment garner a lower return or there simply isn’t any worthwhile investment. This type of moat companies tends to pay out most of their earnings while leaving just enough to maintain current operation. 

It is okay to pay up for moat

To be clear, this doesn’t mean you should buy them at any price. The price you pay still affect the investment return. But for long term investment—the reason for owning moat stocks—return on capital plays a bigger role than the price in determining investment return. For an investment with a 1-year horizon, price decides 95% of the outcome. As the investment horizon lengthens to 10, 20 years, the outcome gravitate towards the business return. For that reason, 95% of your time should be spent on measuring the moat, not whether to pay an extra half a dollar for the price.

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