I was going through my file cabinet, and uncovered an interesting presentation from Morningstart on the Power of Economic Moats. An economic moat is a competitive advantage that allows a company to generate high returns for long periods of time. There are several sources of competitive advantage, which we would cover below.
Having an economic moat allows a business to generate high rates of return on investment over a long period of time. That allows for faster earnings growth, more predictable cashflows and generating excess cashflows too. Businesses with high moats have generated high returns on investment for long periods of time. Duration is very important.
I like the idea of looking at stocks as small pieces of a business, rather than pieces of paper to be traded.
I also like the idea of performing fundamental research, assessing competitive advantages, taking long-term perspective and investing when valuation is right, and odds are in your favor as an investor.
There are five source of sustainable competitive advantage.
- Intangible Assets
- Switching Costs
- Network Effect
- Cost Advantage
- Efficient Scale
Intangible Assets includes things like brands, patents and regulatory licenses. A few examples of companies with strong intangible assets listed include Johnson & Johnson, Unilever, Coca-Cola, Sanofi.
Switching costs include the ability to effectively lock in a customer into an arrangement that would make it extremely costly for them to switch. A few examples include ADP, Oracle, and Intuitive Surgical.
Network effect is when the value of a particular service increases for new and existing users as more costomers are added. A few examples listed include Mastercard, Ebay, Facebook, CME Group.
Cost advantage is when you have lower costs than your competitors for a variety of structural reason. A few examples listed include Amazon, Novo Nordisk, Shell and ABInbev.
Efficient Scale is when a market of limited size is served by a few companies, a monopoly or dupopoly of sorts.
Moats are not static. They expand or collapse.There are changes in industry dynamics, and management may do silly things that damage the moat.
That being said moats provide a margin of safety, and could provide an advantage if you can snap a good company on sale that has with a durable advantage that would be in business for a while.
Ultimately the important thing is having a unique advantage in business, that allows that business to earn high returns on capital. The longer the duration of that advantage, the higher the possibility for earning money as an investor. If one buys it at a price that avoids overpaying for such quality business, that further increases potential for profits.
The goal of course is to assess the durability of the advantage. The products or services that have wide sustainable and durable moats around them can deliver rewards to investors.
Long-time readers of Dividend Growth Investor are aware of the concepts of moats and the types of companies listed above. Many of them are well-known blue chip names, which have delivered good results and good returns to shareholders. That being said, you can notice some of these entities like ABInbev have had their fortunes reversed. But others have had their fortunes continuing to prosper, e.g. ADP and Mastercard. Note this presentation is from over a decade ago, and still overall holds its ground.
