Here are the top learnings of this post:
– You will hear Pat Dorsey talk about Morningstar types of economic moats.
– You will have a clear understanding of what they mean and what you need to look for in order to find them.
– You will learn the cautions to keep in mind when looking for them and not be lured into looking-like-but-mistaken moats.
“Does the stock you’re interested in have an economic moat?”
You know the power of competitive advantage over the long term and you have made your investing strategy to look for such companies.
Maybe you follow your instinct, your taste and love for some products, or you listen carefully to your environment, TV commercials, radio announcements, etc. Eventually, you discover a company in an industry that interests you, seems to have an economic moat, and you ask yourself the ultimate decision question:
“Does the stock you’re interested in really have an economic moat?”
Fortunately for you, you’re not the first entering this long term investing path. Some investors that have done well in the past decades have proven the strategy efficiency, and have made the research for you.
Actually brought to the financial world for the first time by Warren Buffett, the moat concept was then investigated and deeply tested by the Morningstar equity research department.
Pat Dorsey, back then Director of the department, led his team to test and valid types of moats found over thousands of companies investigated all around the world.
They managed to come up with 4 main types of economic moats that you could find in a competitive advantage company that is likely to do well over the long term.
So, what should you look for as a sign? Here are the 4 stars to seek in order to confidently invest in economic moats stocks over the long term.
1) Intangible assets or the hidden path to glory
The first category the Morningstar team has been able to find is “Intangible assets”. Somehow hidden, you have to investigate to find them.
Generally speaking, this category consists of brands, patents and regulatory licenses.
So you say you have a brand, huh?
Who hasn’t been over-washed with Nike commercials over the past decades?
Everybody remembers Michael Jordan and his “Just do it” marketing power.
Who wouldn’t love to look like such brandable champions Nike endorses?
The company has a great presence in the mind of the public when it comes to sports. This kind of power has the ability to build a sustainable growth over the long term.
That’s the power of brands you are looking for.
You need to be cautious though when it comes to looking for brands.
Don’t make assumptions as all big-branded companies don’t necessarily have a value brand. Such a believe has already turned worthy investors down in the past.
What you need to figure out is the following: “Is the brand of this company increasing the consumer’s willingness to pay for its products or services, or does it improve the customer’s captivity?”
If the answer is a resounding “yes”, then you may be in the presence of a valuable brand.
“Aren’t you concerned? Oh, I think it’ll be okay for next time, as per usual.”
God exists, and this can be considered as the highly protected treasure of successful companies.
Getting legal protection for the use of your product or service and barring the competition from trying to replicate your business is possible. And patents are a way to do such a thing.
You can get a glimpse of this kind of moats by looking at pharmaceutical companies. Their medicine are most of the time only produced by them only, so they can enjoy the entire benefits for a sustained period of time.
Now, here’s the ugly truth.
Patents can’t always be a reliable type of moat.
Not only can’t they last forever, but they can also be challenged.
Patents have to be renewed in the eye of Law and are only available in the short term. You can imagine what could happen if it’s not renewed.
Most importantly, patents are legally subject to challenges by other firms.
Actually, some law firms are explicitly specialized in this kind of sues. So, you better have a good loyal and competent army of lawyers to detract these vultures from taking away your profit protection.
Now, you can highly be sure that a company will maintain its sustainable patents moat if the data clearly shows the company has invested consistently and highly in R&D over the past ten years to issue new highly profitable patents.
Only by overseeing past action can you make yourself a good idea of what the patent efficiency and protection will be in the future.
Don’t worry. I have the government backing me up.
Imagine that authorities act in your favors by issuing regulations that only you can bear.
This makes you the only one able to operate in a market that is controlled by regulations: The DREAM.
Competitors can’t enter the market and challenge you. There you are, alone in the realm of growing benefits.
Now, not every business operating in an industry and benefiting for regulation licenses are great businesses. Some licenses are so strongly regulated that prices are strictly decided by authorities, generating potentially under-regular operating margins and low returns on capital.
Such companies must then have a management in place capable of reducing costs, which is another dish on the table.
2) Why don’t you get the brand new Lenovo? Well, I think I’ll stick with Apple.
Have you ever lived this kind of situation?
You are looking to make a purchase and you happen to be torn between multiple offers.
But somehow, you are convinced that one product is the best? It may not be the cheapest, the most beautiful, the most useful, but you find it, for some reason that belongs to yours, the best product.
And you are willing to make the necessary arrangements in order to buy it.
Such a product is a gold mine.
Those products have such a Switching Cost that customers are not willing to change them, even if the price is higher than competition.
Such products are the Apple Mac Series.
Apple can charge a premium, compared to competition, and still get customers loyal and happy about their products. The change of software would be somehow a problem for the customer as some applications don’t work nor are available on PC.
This is the kind of deal you’re looking for.
When you ask yourself the question “If I was given the opportunity to get another similar cheapest product, would I get it?”, if you can answer with a high level of confidence “No, I would be better off with the one I got. In fact, I would get a new one”, then chances are you are in possession of product that gives its maker a very nice and valuable competitive advantage.
3) And you call it the Snow Ball Effect.
Imagine you have a business that literally gets more valuable every time it is known or used by one client?
It’s easy to see that such a business would expand exponentially in a very fast way.
Because they tend to expand globally very quickly, such businesses are treasures to investors. They are developing so fast that competitors, even if they have the means, can’t keep up with the business expansion’s pace.
Such a entrance barrier!
You can find such businesses with companies like Western Union for example.
Good chances are that the hard-working parent in Mexico will use one of the thousands convenient locations to send money to his exchange Mexican student in the USA.
The service is so useful that the later hired student won’t hesitate to use the same service to send money in return (and that’s when parents are happy :)).
The key with these businesses is their omnipresence. Everywhere you go you can find a business using VISA cards or AMERICAN EXPRESS cards. If you would like to start a business in the same industry, you would very hard times, if not impossible, to match with those mastodons.
And this is called the Network Effect, spreading exponentially while expanding.
4) How did you get such a price for it? I know a guy.
All previous types of moats are moats allowing the businesses to charge a higher price, fueling the profits generating from operations and ultimately the returns for investors.
This last type of moats emphasizes on the other side of generating profits: Instead of charging more, profits can be improved by reducing costs. This is the Cost Advantage type of moat.
This can rise from a better provider, a better production process, a better management team that globally reduces costs, economies of scale, etc.
Any way that allows that and that you can highly confidently be sure of lasting is a sure cost advantage type of moats.
Now, all of those moats can be found, and some businesses can compel many of them. Finding such businesses are the source of considerable wealth.
I wish you to find such companies, and to enjoy your investing plan.
To your investing success and moats digging,