We met Pat Dorsey in Singapore during pre-covid days when he publicized his book– The five rules for successful stock investing. We find a lot of common ground with Mr Dorsey’s thoughts and we’d like to share some of the learnings that we picked up.
Moats refer to entry barriers or a sustainable competitive advantage that a business has.
Economic moats are NOT these things
1) Great management
Excellent management alone is not a moat. Management does matter to help expand or destroy a moat over time. It is not a solution to all problems.
In a study by Harvard business review in 2015 by José Antonio Marco-Izquierdo – Profit is less about good management than you think. The economic moats are more important than management. Inditex (owner of the brand Zara) founded in 1963, one of the biggest fashion group had only 2 CEOs succeed the founder Amancio Ortega. In comparison, the CEO turnover in other low moat businesses tend to be multiple times higher. In evaluating moats focus more on the business and less on management. Whenever you walk into a BMW / Toyota car showroom, do you know who the CEO is?
2) “Best” and latest technology
Having the latest technology is also not a moat. Why?
Often, competitors will try to replicate these technologies or hire top engineering talent from them. We have seen this happen time and time again. High returns of capital will be competed away if there are low barriers of entry.
A few years ago, Apple hired chip design engineers to migrate away from Intel chips and build its M1 chip processer to power its laptops. Recently, they are giving incentives to prevent virtual reality engineers from moving over to Meta (Facebook).
Microsoft was not the first to invent the desktop productivity software (remember WordStar, WordPerfect, Lotus 123 – if not – good for you). Neither did it have the best technology at that point. But today, most corporations would not be able to survive without its Microsoft office productivity software.
3) Large market share
Market share can be misleading. On the one hand, it could indicate that the company has a strong moat and has gained market share over its competitors. But it does not mean that the market share is sustainable over time.
Nokia is a case in point.
At the peak of the market in 2007, Nokia had about half the market share of mobile phones. It took a couple of years for Nokia phones went from being the must-have handset in your pocket to the long-forgotten handset. I’m sure you remember this handset for those who are “young” enough.
Today, many Chinese players that dominate the market did not produce mobile devices then.
What then are Economic Moats?
A) Intangibles – brands / patents
These allow companies to charge a significant premium for their products or services. Starbucks for example charges a premium for its coffee as compared to any no-brand coffee.
B) High switching cost
Take core banking software; these are software that banks use for managing deposits, payments, loans ,or Automated Teller Machines (ATM).
The bank’s legacy software has been around for a long time. It is not the latest and greatest cloud technology out there. Banks are reluctant to switch software vendors even if it’s slightly cheaper. The risk of failure or missing bank deposit data during software migration can cost the bank much more pain than trying to save a few pennies. Imagine what happens when you go to the ATM and realise that your bank account balances are wrong.
C) Network effect
As more customers use their product or services, its benefit becomes more valuable to its users. The internet is a good example. As more people post content on it, search engines like Google become more beneficial for all its users.
D) Low-cost advantage
These companies sell the same product at a significantly lower cost than their competitors. This could be gained from having economics of scale or access to a low-cost resource. One of the largest retailers globally, Walmart has the ability and scale to pass on these savings to its customers.
Do not be fooled when a broker calls you up and asks you to buy a stock because the management is fantastic or it has the latest technology and is gaining share from others. Look out for real economic moats.