How to Find Wide Investment Moats the 'Easy' Way
Finding a wide investment moat is critical to investing, especially for the long term; Warren Buffett's simple-is-better philosophy extends to his ability as a teacher to take complex subject matter and turn it into something we can...
As a rule, Warren Buffett invests only in castle and moat businesses. These businesses, as Buffett himself has described, are wonderful businesses with durable competitive advantages. The extension of this metaphor might be that castle and moat businesses are strong businesses built upon a winning business strategy and strategic brand, and which have high barriers to competitor imitation and entry.
Finding a company with a strong competitive advantage like an Apple is what every investor is looking for. It is not easy and there are not a lot of formulas that you can use to find them.
"But all the time, if you’ve got a wonderful castle, there are people out there who are going to try and attack it and take it away from you. And I want a castle that I can understand, but I want a castle with a moat around it." - Warren Buffett from a talk he gave to MBA students at the University of Florida.
"A moat refers to business' ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms." (please recheck 'investopedia' on this Def.)
Another concept that Buffett refers to is a promise or a share of mind. By this, he is referring to a given brand and the promise of quality a consumer can expect from that brand.
Trust & Reputation
It's all about trust and reputation. Think of Coke. When you open that bottle you know exactly what you are going to get every time. You trust the quality and taste. This gives consumers confidence and reduces their risk of spending money for something they won't like.
And for Coke, it gives it branding power, which can enable it to raise prices because people will often pay more for a brand they know and trust as opposed to an unknown or unfamiliar brand that is cheaper.
This is also great for Coke because the branding helps with creating customers who will keep coming back for the product which helps create predictable and steady cash flows.
Charlie Munger on investment moats
"The difference between a good business and a bad business it is that good businesses throw up one easy decision after another. The bad businesses throw up painful decisions time after time." - Charlie Munger
Buffett and Munger have both said that they prefer to find great moats and buy them as opposed to trying to create them. They feel it is easier that way, and they feel they are better at locating them than creating them.
At the 2012 Berkshire meeting, Munger said: "We buy barriers. Building them is tough. Our great brands aren't anything we've created. We've bought them. If you're buying something at a huge discount to its replacement value and it is hard to replace, you have a big advantage. One competitor is enough to ruin a business running on small margins."
For example, he believes that you don't need to make hamburgers to see that McDonald's has a moat. But don't dream of building a burger joint to compete with them without someone like Ray Kroc running the show.
Five types of moats
Type 1: Supply side economies of scale
Type 2: Network effects
Simply, this is a result of a product or service becoming more popular as more people use it. A great example of this would be Google. It has two extremely monstrous network effects with the Google Search and Google Ads. Google is so popular that it has become a verb. To Google it. Think about it. We all say we are going to Google something, as opposed to looking up the information. It has become so entwined in our culture that we all know what it means to Google something.
Type 3: Brand
This is probably the easiest and most recognizable moat there is. Most people can pick out a brand moat. Examples would be Coke, Nike, Apple, Amazon, Disney. All of these companies bring a different idea to mind when you think of them, but they are all instantly recognizable.
The power of a brand moat comes into play when a company can raise it's prices and no one cares. Think about Disney and the price of going to one of its parks. It is not cheap, but it is an experience one will never forget so you pay the price because you want that experience that you can't get anywhere else.
This is the power of a brand.
Type 4: Switching costs
Products and services that are not easily abandoned for a substitute or a competitor's product.
Several examples that spring to mind would be Apple. Once you are a part of its ecosystem it is very hard to leave for Android, for example. Once you have the iPhone or a Mac, it is hard to go back to Windows or Android.
There may be aspects of Android you might like, but the cost in time and money makes it prohibitive to switch. Another example would be your bank. Switching your bank accounts is a royal pain in the butt. With automatic payments for everything now it is very labor intensive to switch banks.
Type 5: Patents and intellectual property
Companies granted patents are given a legal monopoly for as long as that patent exists. No other company can utilize that formula or product until the patent expires. An example would be pharmaceutical drugs for which they get patents. Once they achieve that status and the drug finds a niche for the disease it is treating, that company will enjoy a monopoly until that patent expires.
There are no guarantees in investing, and you always have to keep that in mind when you are considering any investment. Just because the numbers line up doesn’t necessarily indicate that you have a true moat.
Sometimes it is just a matter of the sniff test. If it smells like a moat, then it probably is. Take Coke, for example. It is such an indelible part of our society at this point and time, but with the winds of change in people's health choices, it has chosen to start buying juice companies, water companies, and others to start diversifying its portfolio of offerings to appeal to those tastes.
This is incredibly smart to try to adapt, and this is one of the ideas that makes it great. Another thought to keep in mind when you are searching for a wind investment moat is the valuation of that moat. Just because you discover one, it doesn't mean you should buy into it at any price.
Therefore: The price has to make sense, too!
Disclaimer: Ralph Gollner hereby discloses that he directly owns securities of some of the stocks mentioned above: Google/Alphabet (GOOGL), Amazon (AMZN), Apple (AAPL), Mc Donald's (MCD) as per 5th April 2017.
Disclaimer/Hinweis nach §34 WPHG zur Begründung möglicher Interessenkonflikte: Aktien von Google/Alphabet (GOOGL), Amazon (AMZN), von Apple (AAPL), Mc Donald's (MCD); somit Unternehmen, die in diesem Blogeintrag/Artikel behandelt/genannt wurden, befinden sich aktuell im "Echt-Depot" von Mag. Ralph Gollner - per 5. April 2017.