Moat investing is a specific subbranch of value investing that looks at companies with a relatively higher ‘moat’.

Wait what is a moat?

Imagine a medieval castle surrounded by a deep, wide moat filled with crocodiles, alligators, and other formidable creatures. This moat serves as a protective barrier, making it nearly impossible for enemies to breach the castle’s defenses. In the world of investing, a company’s moat serves a similar purpose – it acts as a protective barrier that shields the company from competitive threats and allows it to thrive in its industry. Essentially, a moat is a set of characteristics that gives a company a sustainable competitive advantage.

Now that we’ve demystified the concept of a moat, let’s delve into the traits that companies with wider moats possess:

1. Switching Costs

Imagine you’re a loyal customer of a software platform, and you’ve invested years learning its ins and outs. Switching to a competitor’s platform would not only be costly in terms of money but also in terms of the effort, time, and psychological toll it would take to adapt to a new system. Companies that can create these high switching costs for their customers possess a valuable moat. These switching costs provide pricing power, as customers are less likely to leave, and companies can charge a premium for their products or services.

2. Intangible Assets

While some assets are easy to see and quantify, others are intangible but equally valuable. Intangible assets such as brand recognition, patents, and regulatory licenses can form a formidable moat. These assets can either prevent competitors from duplicating a company’s products or give the company the ability to charge premium prices for its unique offerings. Think of the trust consumers place in a well-known brand or the exclusive rights granted by a patent – these are invaluable intangible assets that contribute to a strong moat.

3. Network Effects

Have you ever used a social media platform or a messaging app? The more people that use these platforms, the more valuable they become, right? This phenomenon is known as a network effect, and it plays a pivotal role in moat investing. Companies that benefit from network effects see the value of their products or services grow exponentially as their user base expands. Each additional user makes the product or service more appealing, creating a self-reinforcing cycle of growth that competitors find challenging to break into.

4. Cost Advantage

Imagine two companies producing identical products, but one can do it at a significantly lower cost than the other. The cost-efficient company has a distinct advantage – it can either sell its products at the same price as the competition and enjoy higher profit margins or choose to undercut its rivals. Companies with a cost advantage often dominate their industries, making it challenging for competitors to gain a foothold.

5. Cost of Capital

In some industries, the barrier to entry is not just high; it’s insurmountable. This is because potential new competitors have little incentive to enter the market. Doing so would not only require substantial investments but would also lower the industry’s returns below the cost of capital. As a result, the existing players in the industry enjoy stable profits and a strong moat, guarding against new entrants.

Now this begs the question, How do you find companies with ‘wide moats’? Unfortunately there is no automated way to do this since many of the traits above are pretty subjective. For example, how do you break down ‘brand value’ of a company into a single metric?

This post I try to achieve the impossible and come up with a systematic way to reliably choose a few stocks with widest moats using these traits above.

Methodology

Switching Costs

Its no surprise that B2B companies reign here (with a few notable exceptions). Large businesses with multi-year contracts are much less likely to switch their providers than ordinary users who are much more fickle. There are exceptions such as Apple vs Microsoft or Iphone vs Android since these are powerful entrenched ecosystems. The best way to measure this is using churn rate i.e the fraction of customers who left during a time window from the total number of customers at the beginning of the time window.

Unfortunately churn rate is really hard to measure as this information is pretty hard to find publicly (if you do have a source handy you can let me know). There is a good proxy though, find the companies with the largest consistent margins across their largest competitors. If a company is the top performing business in its sector and maintains a consistent cash flow/revenue margin over its nearest competitor then you can be assured it has a decently low churn rate.

Prominent examples: Apple (iphone ecosystem), Google (search dominance), AT&T (telecom)

Intangible assets

Even harder to measure brand value but easy enough to observe. However there are also a lot of opinions here. For example many folks will wax poetic about Tesla with its state-of-the-art battery technology and revolutionary supply chain that other automakers have not been able to replicate. Or Adobe with all its patents. Or MMM with all of its tiny innovations producing a large variety of household items. There are companies such as IBM and Canon that are hardly in the news but have a huge arsenal of marketable patents they earn royalty from.

Prominent examples: Tesla, Adobe, IBM, Canon, LG, Taiwan Semiconductors

Network effects

Simple enough to compute – these are companies with a steadily growing userbase over a good window of time. If its hard to get user base growth, we can use revenue growth as a proxy as well since user growth often corresponds to revenue growth. However beware of companies with non-existent or negative margins – huge user base growth is more likely bad for them financially. Your household names come to mind – Costco, Home Depot (consumer), Medtronic (medical devices), EPD (natural gas pipelines)

Cost advantage

Also easier to measure, companies in the same sector with a proportionally larger profit margin than its competitors. Eg Pfizer,

Cost of capital

Companies with huge startup costs. Think public utilities and building railway networks or even airlines. There is a reason these companies very rarely go out of business, its just too expensive to enter the space. Its not just the cost of capital but cost of regulation as well. For example setting up a private utilities company requires navigating a ton of bureaucracy and red tape which can cost heavily in terms of legal fees and lobbying costs.