What the heck is a “moat?”
Wolf here: I learned about it while getting my MBA. We used a more academic name. But “moat” makes perfect sense. I’ve dealt with it throughout my career, from both sides of the “moat.” As an investor, I made money because companies had that moat; and I paid a price because I thought they did, when it was just a ditch. Today, the concept is more crucial than ever.
By Chris Mayer, Chief Investment Strategist, Bonner Private Portfolio
A truly great business must have an enduring “moat” that protects excellent returns on invested capital.
— Warren Buffett
At Blue Nile, you could buy a 1.08-carat, ideal-cut diamond with G color and VSI clarity mounted in a platinum band for about $8,948. At Tiffany, the same ring would cost you $13,900. That’s $4,952 more… just to have it in a Tiffany Blue Box.
It shows you the power of a brand. It’s Tiffany’s moat. Competitors can sell the same diamond, but they can’t put it in a Tiffany Blue Box. This fact helps drive stock returns, too.
Blue Nile’s stock is down about 24% since it went public in 2004. That’s more than a decade of no return for investors.
By contrast, Tiffany’s total return (including dividends) is up 45-fold since it began trading in 1987. That’s even after its recent beating.
Tiffany has a moat. Blue Nile does not. (The above example comes from Pat Dorsey’s The Little Book That Builds Wealth.)
So, what’s a moat?
A moat is what protects your business from its competitors. It allows you to do things your competitors can’t do—like charge $5,000 for a blue box. It’s also the engine behind some mega stock winners.
See Starbucks. When it began back in the 1970s, a cup of coffee was about 50 cents. Starbucks got people to pay a couple of dollars for their coffee by playing up the coffee’s quality. It also brought McDonald’s-like quality control to coffee to ensure a cup of Starbucks coffee tasted the same everywhere. This was a big innovation at the time. And it’s made the Starbucks’ brand the powerhouse it is today.
I remember reading about how some of the venture capitalists who looked at Starbucks early turned it down. They couldn’t imagine people paying so much for a cup of coffee… But as you know, the stock has been a monster winner, up more than 16,000% since its initial public offering (IPO) in 1992. And it’s up more than tenfold since 2008.
That’s the power of a great moat.
If you have one, your stock can overcome the most fearsome onslaughts. Look at Coca-Cola, one of the world’s greatest brands. (Warren Buffett likes to use this example.) Coca-Cola went public in 1919. Let’s say you were an investor in 1919, and a man from the future gave you a glimpse of what lay ahead. Depression. Another depression—one that would go on for so long, people would forever call it “The Great Depression.” Wars. Sugar rations. Inflation.
You probably would’ve guessed there were hard years ahead for Coke. Yet if you’d bought Coke for just $40 and reinvested the dividends, you’d have over $5 million today.
When I think of moats, I think of Pat Dorsey. He was the director of equity research at Morningstar and is currently the president of Sanibel Captiva Investment Advisers. Dorsey writes and speaks extensively on moats. He uses this analogy for why you should pay attention to moats:
It’s common sense to pay more for something that is more durable. From kitchen appliances to cars to houses, items that last longer are typically able to command higher prices… The same concept applies in the stock market.
Moats make companies durable by keeping competitors out.
I’m sure you can think of some businesses with great moats. Most people will think of companies with great brand names, like McDonald’s.
But there are many other ways to build a moat. Think about Comcast.
Comcast has miles and miles of cable that lead directly into the homes of millions of Americans. Once you get your Internet connection through Comcast, it’s a pain to switch. That’s an enormous advantage and hard for competitors to crack. And Comcast has been a big winner for a long time, outstripping the S&P 500 with ease…
So, how do you recognize a company with moat? Here are five examples:
- You have a strong brand. Tiffany has a moat, as we saw. People pay up just to get that blue box, even though what’s in the box might cost less somewhere else. Starbucks is a great brand. It inspires loyalty and ensures recurring customers. That’s a moat.
- It costs a lot to switch. Comcast is a good example here. Once you have your email and cable tied up with Comcast, it’s a pain to switch.
Banks can have this kind of moat too. There isn’t much of a competitive advantage that one bank can have over any other. They all have the same products. And with the Internet, branch locations aren’t important.
Yet when you look at the numbers, people tend to stay at their banks for six to seven years. That’s because it’s a pain in the neck to change banks. As economists say, “switching costs” are high. That’s a moat.
- You enjoy network effects. Microsoft had a great networking moat for years. Everybody else used its operating system… so you wanted to too. The more people used Microsoft’s operating system, the more it enjoyed network effects.
There are lots of network moats today. Think of Facebook, Twitter, or YouTube. It’s very hard for competitors to replicate these businesses, to crack the network moat. It’s like trying to sell the first telephone.
- You do something cheaper than everybody else. If you are the low-cost guy, like Wal-Mart, you have a moat. Wal-Mart destroyed many higher-priced retailers.
Interactive Brokers is another example. It’s prices are much lower than every other discount broker. That partly explains why it’s growing twice as fast as its competitors.
- You are the biggest. Absolute bigness can be an advantage if it keeps competitors out. Imagine what it would take to try to replicate the research capabilities of Intel or the purchasing power of Wal-Mart.
Relative size can also be a moat. If you’re the dominant insurer of small taxi fleets, as Atlas Financial is, then you have a moat. Competitors are unlikely to invest the time and energy necessary to compete in what is a niche market.
This is not meant to be an exhaustive look at moats. There are other, subtle ways a company could create a barrier other companies have trouble breaking through.
In essence, moats are a way for companies to fight “mean reversion” (this is like a strong current in markets that pulls everything toward average).
In an unpublished study called “Mean Reversion in Corporate Returns,” Matthew Berry, a Columbia Business School alumnus and former analyst at Lane Five Capital, gives us a great clue to look for in finding moats. His study covers the 15 years from 1990 to 2004. It includes the 4,000 largest companies primarily located in the United States, the U.K., Canada, Germany, France, Italy, and Spain.
Here’s his main finding: High gross profit margins are the most important single factor of long-run performance.
This means that if a company started with a high gross profit margin, it tended to keep it. Conversely, when it started off with a low gross profit margin, it tended to stay there as well. “Gross margins persist,” to use the statistical lingo.
Gross margin is a good indication of the price people are willing to pay relative to the input costs required to provide the good. It’s a measure of value added for the customer. Not every company shows a large gross margin. But those that have it usually get it from some competitive advantage. And these advantages do not tend to disappear overnight.
So, a high gross profit margin is one more clue to a durable moat.
Here are two lesser-known stocks that meet that hurdle. They have great moats. They’ve got track records as winners. Both are on my watch list:
- American Tower (AMT): American Tower owns cellphone towers and leases them out to carriers. Its gross profit margin last year was an astounding 73%. It’s a great business. Once it has a tower in place, it’s tough for a competitor to justify putting up another one in the vicinity. And every “tenant” AMT adds to an existing tower is almost pure profit.
- Liberty Global (LBTYA): Liberty Global is the largest cable operator in Europe with 53.2 million subscribers. (Think of it as Europe’s Comcast.) It’s basically a monopoly. It has a great moat, which translates into rich profit margins. And John Malone, the celebrated 74-year-old cable wizard, controls it. You couldn’t ask for a savvier man at the helm.
Both of these stocks are likely long-term winners thanks to deep and wide moats.
Editor’s note: In Bonner Private Portfolio, Chris and his team focus on strong-moat companies that will build your wealth long term. His recommendations are so impressive, Agora Founder Bill Bonner is investing $5 million of his family trust’s money in them. To learn more about the elite system Bill trusts with his own money, click here.