How to invest

Warren Buffett mentions moats all the time in his talks and writings and emphasizes the importance of finding a company with moats. The thing is, I haven’t come across anything specific from Buffett where he explains how to distinguish and categorize moats but The Little Book That Builds Wealth provides a practical framework that helps any investor to identify economic moats/competitive advantages. Let’s take a look at some of the ideas from the book.

Mistaken Moats

If you know who Warren Buffett is, I assume that you have been introduced to the notion of moats. But what about the mistaken ideas of moats? With our desire to “fall” for our companies, we begin to claim that even a little positive aspect is a moat. However, here are some illusory moats that the book suggests we should be aware of.

1. In the business world “bet on the jockey, not on the horse” does not apply.
No matter how good a manager is, the fact is that many companies operate in a unattractive environments. If you asked a world class chef to serve superb dishes profitably by placing him in a small local diner along the highway, it would be quite a hurdle. There are some exceptions, but we should consider the norm rather than convince ourselves that the exception is the norm.

2. Great products do not create moats.
Remember vinyl discs, cassette tapes, CD’s, video tape recorders, muscle cars, film cameras, Tommy Hilfiger, Netscape? All were great products but none of them lasted. Who knows what will replace the iPod or the AeroGarden. Or what about Krispy Kreme? They have some fantastic tasting donuts but nothing to lure me back when I decide to go on a diet. Unless a company can leverage its product to create an economic moat profits will probably be reaped for a short time.

3. High market share i.e. bigger is not necessarily better.
In highly competitive industries, high market share is not equivalent to a competitive advantage. Kodak (film), IBM (PC’s), Netscape (internet browsers), GM (automobiles), and Corel (word processors) were big companies but they failed to maintain their moat which led to either a demise or a sale. Size can help a company create a moat but it is rarely the source of an economic moat by itself.

4. Operational efficiency that we call “great execution”.
If a company succeeds by being leaner and meaner than its competition, it is probably because the company operates in a very tough and competitive industry where cutting costs is the only way to profit. You can cut and carve a fat cow but once you get to the bone, where is the meat going to come from?

The Real Deal

So talented CEO’s, great products, high market share and great execution aren’t defined as moats. Then what is?

1. Intangible assets
2. High switching costs
3. Network economics
4. Cost advantages

The following sections are excerpts from a 2003 Morningstar article.

Intangible assets

Intangible assets generally refer to the intellectual property that firms use to prevent other companies from duplicating a good or service. Of course, patents are the most common economic moat in this category. In techland, Qualcomm’s (QCOM) CDMA patents give it a strong moat in the cellphone industry. Patents are also critical for drugmakers like Merck (MRK) and Johnson & Johnson (JNJ). A strong brand name can also be an economic moat. Just consider consumer-product companies like Coca-Cola (KO) and Gillette.

High switching costs

Michael E. Porter defines switching costs as a barrier to entry that involves the one-time inconvenience or expense a buyer incurs to change over from one product or service to another. Buyers in these cases often need a big improvement in either price or performance to make the switch to another product worthwhile. Medical-device companies Biomet (BMET) and Stryker (SYK) benefit from high switching costs because, for example, a surgeon would have have to forgo the comfort and familiarity of doing procedures with one artificial joint product. And because the surgeon would have to be trained to use competing products, he or she would also have to contend with lost time and money resulting from not performing as many surgical procedures.

Network economics

The network effect occurs when the value of a particular good or service increases for both new and existing users as more people use that good or service. It can also occur when other firms design products that compliment an existing product, thereby enhancing that product’s value. For example, the fact that there are literally millions of people using eBay (EBAY) is the thing that both makes eBay’s service incredibly valuable and makes it all but impossible for another company to duplicate its service.

Cost Advantages

Firms that can figure out ways to provide a good or service at a relatively low cost have an advantage because they can undercut their rivals on price. Walmart (WMT) is a textbook example of a low-cost producer because its large size allows it to negotiate favorable item costs.

Additional Information

The Little Book That Builds Wealth is written by Pat Dorsey from Morningstar. It is a simple to read book that helps with understanding (and brushing up) what and where moats lie. It also lets the reader see how Morningstar goes about defining moats. Do check out the diagram on page 145 that shows the moat identification and labeling process.

The book is a great read to add and apply to any investors mental model as suggested by Charlie Munger. Pat Dosey also wrote The Five Rules for Successful Stock Investing which covers a lot of the ideas from this book but has more information related to valuations and industry specific advantages and disadvantages.

I have only touched the outline of the book. For a detailed and intriguing read, do consider reading it.