I chanced upon an interesting article by another blogger. In it he talks about business moats (read here).
His definition of true business moat is:
- Brands (eg. Colgate, Swatch & Kao)
- Switching cost
(eg. Facebook, Alibaba, Honda & Johnnie Walker/Diageo for item 3, 4 and 5)
The definition of moat by Morningstar is here.
- Low-Cost Producer or Economies of Scale (eg. Wal-Mart)
- High Switching Costs (eg. Autodesk)
- The Network Effect (eg. eBay)
- Intangible Assets: intellectual property rights (patents, trademarks, and copyrights), government approvals, brand names, a unique company culture, or a geographic advantage. (eg. Harley-Davidson)
To me the definition of a business moat is one critical feature which distinguishes a value+growth investor from a pure value investor. Instead of purely looking at the intrinsic value, margin of safety, low price to book ratios, earnings, and being a contrarian, etc (financial fundamentals) of the company as in the case of value investing, by thinking about the business moat of the company one can have a better grasp of the potential future growth of the company (value+growth investing). It would perhaps lead one to a stock which one can hold ‘forever’. Think of the difference in the investing style of Walter Schloss (whom rarely talked to management, choosing to invest only on the numbers – the tangibles) vs that of Warren Buffett (deep understanding of the operating business, management quality, etc – the intangibles). The issue with finding ‘cheap’ stocks (base on numbers) is that if the company does not have a wide moat, the fundamentals will ultimately deteriorate and the stock will remain ‘cheap’ – so much for holding forever.
“To be successful, you should concentrate on the world of companies, not arcane accounting mathematics.” Warren Buffett
On the other hand, companies with seemingly wide ‘moat’ may not have fantastic fundamentals. Let’s take a look at my own portfolio (which consists of CapitaLand, Golden Agri, SIA, SMRT, Sun Hung Kai , Vicom, SuperGroup, Riverstone, ISOTeam and Colex). Some of my earlier stocks eg. SMRT, SIA, Golden Agri would have qualified as companies with wide moat.
- SMRT (read here) is in an industry (the provision of rail and bus services) with a high barrier to entry and it’s providing a vital service for the public.
- Singapore Airlines is a world renowned brand (read here) with a reputation for being the top luxury airline in the aviation industry.
- Golden Agri is the world’s second largest oil palm company and its vertically integrated operations are among the most efficient and technologically advanced in the industry. It aims to be the fastest-growing and lowest-cost integrated oil palm company in the world.
However, fundamental wise (and stock price wise), their performances are not exemplary. So does that mean having a good moat may not guarantee good earnings. Let’s take a look at some of the companies in my portfolio which has better financial fundamentals eg. Vicom, Riverstone and Colex. Being not as renowned (as SIA or Golden Agri), their moats may not be that apparent. But then again, is it just the moat that is important or the most critical item to be thinking about?
Having a moat is just not enough (and so it seem for SMRT, SIA and Golden Agri) – good companies need strong moat in the right environment. In the case of SMRT, it is in a highly regulated industry – pricing of the fares are not within its control. In the case SIA, it has to content with huge fixed costs, strong labor union and commodity pricing. “It’s been a death trap for investors,” to quote Warren Buffett on airline industry (read here). Golden Agri has to content with commodity pricing and environmental issues. The moat is useful against competitors but does not protect the company from the business environment it is in. It is simply not worth it in business to jump over a 7 foot hurdle (instead of just walking over a 1 foot hurdle). Of course, if the company does not even have some form of moat, then its survival would be in danger.
Moreover moats can be eroded over time (eg. Nokia and Kodak). While some moat has an end date. Take the case of Nagacorp’s monopoly on Phnom Penh casinos not due to expire until 2035 (read here).
Put yourself in the business owner’s shoes and think how would you protect your business against other competitors. This is where the line between investor & business owner blurs.
‘I am a better investor because I am a businessman and a better businessman because I am an investor.’ Warren Buffett.
The lifespan of a typical company is not long (read here). So before we even worry about the stock price fluctuation perhaps it would be more prudent to ponder if the company can survive another 15 years (of course it could be the case of the company being bought over by others due to their good fundamentals).
Being in the construction industry, I can see where some contractor’s moat is in. Take the case of Tiong Seng Holdings Limited – it is one of the very few contractors which owns a prefab hub (read here). For developers, CapitaMalls Asia has a network of tenants for their retail malls, and their extensive number of malls make their vouchers (Capitamall vouchers) popular. To a smaller extend they also bank on their integrated shopping mall business model (Raffles City developments) in China.
While it is worthwhile to read up on the companies business moat, however before you plonk your cash into their stocks, think about their business environment first. Can a company easily generate high profit margin? Sometimes being in a less glamorous, unregulated, less competitive industry (or those selling cheap disposable items which many people would need) would be more important. Then only after finding these companies (those that just need to step over 1 foot hurdles), choose the one with the strongest moat.
We probably can’t change the professional we are in easily, but in investing we do have that freedom. We can choose whichever company in whatever industry to invest in.