My thoughts on moats
Someone was asking about identifying sustainable moats at GuruFocus and I thought I would reproduce most of my answer.
User AugustaBound also linked to a comprehensive Credit Suisse analyst report on moats that you may want to check out: Measuring the Moat: Assessing the Magnitude and Sustainability of Value Creation (by Michael J. Mauboussin and Kristen Bartholdson, Credit Suisse First Boston. December 16, 2002). I plan to read it fully in the future. It may not help investing per se but it might sharpen one's thinking of businesses.
It's Dangerous to Rely on Moats
I think the notion of a moat is overrated—not because it is not important but because it is very difficult to know what is a moat except in hindsight. A classic example is Kodak, which everyone in the 80's would have said had a huge moat. After all, Kodak essentially invented a certain type of film and dominated the market for decades. I don't know all the details and haven't read up on history but I imagine that Kodak also had key patents, had better technology (or at least was able to spend more money if needed) and probably had cheaper manufacturing and distribution (due to economies of scale.) Yet, competitors, particularly Fujifilm, kept stealing away market share. Within 10 or 15 years, Kodak's moat not only weakened but it completely dissapeared. The key reason, of course, was the emergence of digital cameras. Someone who thought Kodak had a big moat in the early 90's would never have seen how it could crumble due to digital photography.
Conversely, 5 years ago, almost everyone would have said Amazon not only had no moat but would never develop one (because bricks & morter retailers were more dominant and had free cash flow to crush any dot-com). Yet Amazon ended up having a moat—at least in my opinion.
How Do I Identify Moats?
I'm still a newbie thinking my way through all this so I can't say I know some magical method to identify moats.
The way I identify moats is by looking at long-term market share and ROE. If a company has, say, 40% of the market share for a decade or more (like Diageo in the hard liquor business) it likely has a moat. It is very important that you think about the long term, spanning several decades if possible. There are many businesses that seem to dominate but they are simply riding a macro trend—usually based on hype or some fad—and can falter.
Moats should show up as high ROE (say 15%+) for a long period of time. As Buffett has suggested, American businesses have a very-long-term ROE of around 12%. If you see a business with a higher ROE then it likely has a moat. Competitors would be attracted to the higher returns yet are unable to dislodge the company. Many leading companies like Coca Cola, Pepsi, Johnson & Johnson, Microsoft, and P&G generally have ROEs over 20%. This goes to show how powerful they are.
But it is worth keeping in mind that ROE can be misleading at times because it can be boosted by debt (e.g. Diageo), can be high for certain business structures with low assets (e.g. Avon) and so on. Like the P/E ratio you can't just blindly take the number without thinking it through. Overall, I think ROE is a good way to discern a moat.
Sustainability of Moats
The message board poster was asking how one can identify the sustainability of moats. I think the question is really tough to answer. In my opinion, the ultimate sustainability depends on macro factors largely unpredictable (unless you were a good macro investor).
A good example is newspapers. As recently as 15 years ago—actually it's even less and more like 5 years ago, because, even in 2004, New York Times (NYT) stock price was trading within 10% of its all-time peak!—I think most people, including many superinvestors, would have said that established newspapers have a huge moat. Yet, now the whole industry is in shambles. The reason, of course, is the development of the Internet. How many could have predicted the rise of the Internet? I would say very few.
Even with companies like Coca-Cola, the moat is highly questionable in my eyes (I know this is a controversial thing for me to say :) ). Historically it has had a huge moat but—I don't follow the company so someone correct me if I'm wrong—a lot of its growth in the last few decades has come from non-cola (i.e. juices, bottled water, and the like). The other areas (juices, etc) provided incremental profit over the last decade or two. As a distant observer who does not follow the company, I don't think Coca-Cola has a strong moat in non-cola products. All it takes is an unpredictable macro event—say people become health-conscious and start dumping sugary liquids—and what seemed like a strong moat can evaporate instantly.
Most people would consider what I said of Coca-Cola to be pretty dumb. But even if you don't believe my view, just think about how vulnerable the moat is. Here we have a company with super-strong moat and some guy off the street (that's me) is suggesting it can dissapear very quickly. I'm not predicting the moat will dissaper; I'm just trying to point out how one should be careful with them.
The Risk With Moats
The problem with moats is that the market generally recognizes it (there is an exception that I will discuss in the side note at the bottom.) You or I may think we are smart for identifying the moat of some company but the market has identified it in advance. This means that most people are paying fair value or higher. I see a lot of so-called value investors buying companies with a strong moat at fair value—with very little margin of safety! Yet, if the moat weakens, the company is going to get killed. An example in my eyes is Wal-mart.
I don't follow Wal-Mart closely but I don't think it has ever been cheap since the early 90's. So anyone buying it has done so with very little margin of safety. Warren Buffett, I will note, purchased Wal-Mart early in the decade but I believe his return on investment is probably no more than the dividend yield of around 2% (that is, his price return is probably close to 0%, while his only earnings have come from the dividend.) Buffett, as is commonly understood, owns a huge portfolio and is limited in his choices. So, even if he posts 2%, it's acceptable to him. He has negative cost of capital from the float of his insurance companies so he will get a boost from that as well.
Wal-Mart has a huge moat but I wonder about its sustainability. Value investors don't like to speculate on macro trends (it's all guesswork after all) but I'm not a value investor so let's think about the risk in Wal-mart's moat.
On top of Wal-mart never really being cheap, the risk is that, even though it has a huge moat, it can be weakened by unpredictable macro events. For instance, Wal-mart is highly leveraged to world trade. If world trade collapses and/or cost of transporation increases and/or protectionism rises, Wal-mart can easily lose the strength of its moat. Furthermore, Wal-mart is highly leveraged to China. Wal-mart alone imports more from China than 90% of the countries out there! If something adverse happens in China, Wal-mart's moat will weaken significantly.
Now, I'm not a Wal-mart bear and am not predicting any adverse outcomes for it. Instead, all I'm doing here is to present a line of reasoning for why it's hard to predict the sustainability of moats. Moats can be weakened by adverse macro events and it's very hard to predict that.
Final Word
So to sum up, identifying a moat is somewhat easy (by looking at long-term ROE or market share or something like that). But identifying a sustainable one is far tougher than many imagine. It's really an art.
SIDE NOTE:
I think the market misprices moats of distressed companies. We can look at some of Buffett's famous picks to see how the market misread the moat. Examples such as American Express in the 50's or or Geico in the 70's come to mind. I would say other situations like IBM in the 90's are also similar. American Express's moat never weakened even during the Salad Oil Scandal. What weakened was the financial position and risk of bankrupty; but its moat remained strong. My goal is to seek out opportunities like these. So far I haven't had any success but this is one of my key strategies I am pursuing. The problem with this strategy, though, is that distressed firms are a minefield and you can get blown up easily. Anyone following this blog for a long time may recall how the vast majority of companies on my contrarian watch list have gone bankrupt or have seen massive permanent impairments.
User AugustaBound also linked to a comprehensive Credit Suisse analyst report on moats that you may want to check out: Measuring the Moat: Assessing the Magnitude and Sustainability of Value Creation (by Michael J. Mauboussin and Kristen Bartholdson, Credit Suisse First Boston. December 16, 2002). I plan to read it fully in the future. It may not help investing per se but it might sharpen one's thinking of businesses.
It's Dangerous to Rely on Moats
I think the notion of a moat is overrated—not because it is not important but because it is very difficult to know what is a moat except in hindsight. A classic example is Kodak, which everyone in the 80's would have said had a huge moat. After all, Kodak essentially invented a certain type of film and dominated the market for decades. I don't know all the details and haven't read up on history but I imagine that Kodak also had key patents, had better technology (or at least was able to spend more money if needed) and probably had cheaper manufacturing and distribution (due to economies of scale.) Yet, competitors, particularly Fujifilm, kept stealing away market share. Within 10 or 15 years, Kodak's moat not only weakened but it completely dissapeared. The key reason, of course, was the emergence of digital cameras. Someone who thought Kodak had a big moat in the early 90's would never have seen how it could crumble due to digital photography.
Conversely, 5 years ago, almost everyone would have said Amazon not only had no moat but would never develop one (because bricks & morter retailers were more dominant and had free cash flow to crush any dot-com). Yet Amazon ended up having a moat—at least in my opinion.
How Do I Identify Moats?
I'm still a newbie thinking my way through all this so I can't say I know some magical method to identify moats.
The way I identify moats is by looking at long-term market share and ROE. If a company has, say, 40% of the market share for a decade or more (like Diageo in the hard liquor business) it likely has a moat. It is very important that you think about the long term, spanning several decades if possible. There are many businesses that seem to dominate but they are simply riding a macro trend—usually based on hype or some fad—and can falter.
Moats should show up as high ROE (say 15%+) for a long period of time. As Buffett has suggested, American businesses have a very-long-term ROE of around 12%. If you see a business with a higher ROE then it likely has a moat. Competitors would be attracted to the higher returns yet are unable to dislodge the company. Many leading companies like Coca Cola, Pepsi, Johnson & Johnson, Microsoft, and P&G generally have ROEs over 20%. This goes to show how powerful they are.
But it is worth keeping in mind that ROE can be misleading at times because it can be boosted by debt (e.g. Diageo), can be high for certain business structures with low assets (e.g. Avon) and so on. Like the P/E ratio you can't just blindly take the number without thinking it through. Overall, I think ROE is a good way to discern a moat.
Sustainability of Moats
The message board poster was asking how one can identify the sustainability of moats. I think the question is really tough to answer. In my opinion, the ultimate sustainability depends on macro factors largely unpredictable (unless you were a good macro investor).
A good example is newspapers. As recently as 15 years ago—actually it's even less and more like 5 years ago, because, even in 2004, New York Times (NYT) stock price was trading within 10% of its all-time peak!—I think most people, including many superinvestors, would have said that established newspapers have a huge moat. Yet, now the whole industry is in shambles. The reason, of course, is the development of the Internet. How many could have predicted the rise of the Internet? I would say very few.
Even with companies like Coca-Cola, the moat is highly questionable in my eyes (I know this is a controversial thing for me to say :) ). Historically it has had a huge moat but—I don't follow the company so someone correct me if I'm wrong—a lot of its growth in the last few decades has come from non-cola (i.e. juices, bottled water, and the like). The other areas (juices, etc) provided incremental profit over the last decade or two. As a distant observer who does not follow the company, I don't think Coca-Cola has a strong moat in non-cola products. All it takes is an unpredictable macro event—say people become health-conscious and start dumping sugary liquids—and what seemed like a strong moat can evaporate instantly.
Most people would consider what I said of Coca-Cola to be pretty dumb. But even if you don't believe my view, just think about how vulnerable the moat is. Here we have a company with super-strong moat and some guy off the street (that's me) is suggesting it can dissapear very quickly. I'm not predicting the moat will dissaper; I'm just trying to point out how one should be careful with them.
The Risk With Moats
The problem with moats is that the market generally recognizes it (there is an exception that I will discuss in the side note at the bottom.) You or I may think we are smart for identifying the moat of some company but the market has identified it in advance. This means that most people are paying fair value or higher. I see a lot of so-called value investors buying companies with a strong moat at fair value—with very little margin of safety! Yet, if the moat weakens, the company is going to get killed. An example in my eyes is Wal-mart.
I don't follow Wal-Mart closely but I don't think it has ever been cheap since the early 90's. So anyone buying it has done so with very little margin of safety. Warren Buffett, I will note, purchased Wal-Mart early in the decade but I believe his return on investment is probably no more than the dividend yield of around 2% (that is, his price return is probably close to 0%, while his only earnings have come from the dividend.) Buffett, as is commonly understood, owns a huge portfolio and is limited in his choices. So, even if he posts 2%, it's acceptable to him. He has negative cost of capital from the float of his insurance companies so he will get a boost from that as well.
Wal-Mart has a huge moat but I wonder about its sustainability. Value investors don't like to speculate on macro trends (it's all guesswork after all) but I'm not a value investor so let's think about the risk in Wal-mart's moat.
On top of Wal-mart never really being cheap, the risk is that, even though it has a huge moat, it can be weakened by unpredictable macro events. For instance, Wal-mart is highly leveraged to world trade. If world trade collapses and/or cost of transporation increases and/or protectionism rises, Wal-mart can easily lose the strength of its moat. Furthermore, Wal-mart is highly leveraged to China. Wal-mart alone imports more from China than 90% of the countries out there! If something adverse happens in China, Wal-mart's moat will weaken significantly.
Now, I'm not a Wal-mart bear and am not predicting any adverse outcomes for it. Instead, all I'm doing here is to present a line of reasoning for why it's hard to predict the sustainability of moats. Moats can be weakened by adverse macro events and it's very hard to predict that.
Final Word
So to sum up, identifying a moat is somewhat easy (by looking at long-term ROE or market share or something like that). But identifying a sustainable one is far tougher than many imagine. It's really an art.
SIDE NOTE:
I think the market misprices moats of distressed companies. We can look at some of Buffett's famous picks to see how the market misread the moat. Examples such as American Express in the 50's or or Geico in the 70's come to mind. I would say other situations like IBM in the 90's are also similar. American Express's moat never weakened even during the Salad Oil Scandal. What weakened was the financial position and risk of bankrupty; but its moat remained strong. My goal is to seek out opportunities like these. So far I haven't had any success but this is one of my key strategies I am pursuing. The problem with this strategy, though, is that distressed firms are a minefield and you can get blown up easily. Anyone following this blog for a long time may recall how the vast majority of companies on my contrarian watch list have gone bankrupt or have seen massive permanent impairments.
Good post. While I agree WMT isn't exactly cheap cheap, I see WMT has having a much bigger moat than based on trade.
ReplyDeleteWhile they do import a lot from China, WMT's additional moat is its muscle power. It can get the same product from vendors at a much cheaper price than any competitor can. In retail where 1% makes a huge difference, WMT is far ahead of the game.
I've never looked at WMT myself but I'm sure there are other things that make it virtually a man of steel.
Jae, you have probably notice that I have an opinion on everything even of things I know nothing about. Retail I think I know a little about. It is a sector that historically has no moat. Given the number of products and client contacts is very difficult to build a brand (however there are some exceptions in Spain and Japan) and initial supply chain advantages tend to disappear because of modularization and access to their competitors of these advantages (Li Fung). Also demographic trends are very difficult to navigate.
ReplyDeleteThere is an excellent McKinsey analysis and a HBS case that tackle the sources of Walmart profitability and it is mainly its IT/supply chain investment and its monopolistic pricing in small towns. Surprinsingly the advantage of large scale buying isnot that big. And thinking about, if it were that important KMart, Sears and Marks and Spencer would not be having the problems they are having.
Those two advantages can erode, and I would argue that they are being eroded already. It runs in circles of 30 years where new innovations that underserved the market finallly become mainstream (A&P->Supermarkets->Superstores, Nickel&Dimes->Department Stores->Wal-Mart) while the leader becomes isolated in higher margin items/products. You can see the internal and market pressures on Wal-Mart and Tesco to look for growth upstream (healthcare, financial, fashion) and the start to overserve their markets. Check Christensen's Innovators Dilemma to check how that process works.
If I were Walmart I would be very concerned about hard discounters (Aldi, Lidl, Save-a-Lot), dollar stores, warehouse clubs and internet new models (eBay, Amazon). They work with much lower gross margins (10% vs 20%), lower expenses, and higher turnover. Most of them have been to enter small towns. And changes of competitive advantages of trucks vs railroads can have a lasting impact in the managing of supply chains.
Plan Maestro you know I respect your opinion very much and there is always a nuggett of brilliance in your posts.
ReplyDeleteGoo point about the other competitors. I didn't really consider other game changing businesses with new and leaner strategies.
But my opinion is that with the discounters, I think they operate in a niche. They will never be big enough to change the industry. Thrift stores have been around just as long as any supermarket but there is a limit I believe.
When times get tough, people may go cheap but WMT provides the perception of cheap with quality. I go into any dollar store and I know that it's good for one time use.
I also meant that WMT has the power to purchase the same products at a much cheaper price. e.g. Clorox may charge WMT $1 while it charges everyone else $1.50.
At the same sale price, WMT obviously has the distinct advantage. It's probably the same with every other vendor so regardless of whether they import from China or overseas, vendors are willing to give WMT a better deal just to get on their shelves.