IFB196: Investing in Companies with Wide Moats

Welcome to the Investing for Beginners podcast. In today’s show we discuss:

  •  Best way to think about moats and their impacts on business
  • Some ways to find moats, plus ideas about protecting those moats
  • Impacts of moats, plus buying beyond the best business, price you pay matters.

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Announcer (00:02):

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Dave (00:32):

All right, folks, welcome to Investing for Beginners podcast. Tonight. We have episode 196, and tonight we will return to answering some great listener questions that we got recently. So I’m going to go ahead and read the first question I have. Hi Andrew. Thank you for all the work you and Dave put into their podcast. It’s great to have a rational voice, emphasizing the need for value investing in a field whose boots swings harder than Mr. Market. My question for you both is about the concept of economic moats. Thanks to your explanation of Buffett’s concepts. I understand to finding a great company with a wide moat is essential to value investing, but it seems like the concept of a moat can be a bit abstract for newcomers into investing. I’ve been trying to think of businesses synonymoatus with an industry like Google for search engines. Is there a formula or ratio to look for that would help someone researching a company to find the potential for a wide moat? Thank you for your help, Sam. So Andrew, what are your thoughts on Sam’s really good question.

Andrew (01:33):

So let’s start with maybe some of the beginner kind of explanation of what the moat is. So if you know, if you can picture a moat, basically let’s go back to the middle ages of the times when they had castles. And, back then, there was a lot of violence. People always want to steal your stuff. So you would build a castle and build really big walls to keep invaders away and be able to protect everything you’ve worked so hard for. And another way you could do that besides a wall is also build a ditch around the castle, fill it up with mud and water and everything.

Andrew (02:11):

And that way, you know, they can’t take battering Rams to break down your castle. So that was a very effective way to protect yourself back then. Now in the business world, there’s a lot of similarities to that. Where when you’re a business, who’s making a ton of profit. That’s very good for you, but the downside to that is the moatre profit you make. The moatre attention you’re going to attract from competitors who will want some of that profit. And so, as they come into your industry, they will start to chip away at everything you’ve built. And so, a great example of this was what Amazon did. Amazon came into the retail space and completely slashed prices on everything. And so what that does for you as a business, if you used to do very well now you’re coming in to against the competitor.

Andrew (03:00):

Who’s slashing prices. There’s not much you can do. And you know, you’re kind of, you’re screwed if you do screw, if you don’t, you know, you lower prices to match Amazon, and there go all your profits. If you don’t, Amazon takes all of your customers. So that’s why you have the concept of a moat because if you are a business who has something special about it, competitors cannot just come in and aggressively cut prices to steal business. If you’re able to defend against that, then you have a moat. And so people like Buffett and people like us like to invest in companies like that because if you’re in the business world, you’re going to attract competition. So you need to have some competitive edge that allows you to fight away the competition and continue to grow and continue that profits over time. And so that’s what the moat is the answer to why, where, how you find the Moate and what that means for business is a whole other topic on its own.

Dave (04:00):

Yes, it is. And lots and lots and lots go into a moat. But I think Andrew described it very, very well, and he put it in a great way that you can visualize it. And I think the biggest thing you need to think about when you’re trying to think about moats is you need to think about the company’s competitive advantage. So let’s, let’s take a company, for example, let’s look at somebody like, I don’t know, Amazon or Apple, those companies have arguably a pretty wide moat, depending on what viewpoint you’re looking at. So, for example, let’s take Apple because I think that’s maybe a little, maybe a little more clear, not always the clearest, but it can be. So when you think about Apple, you think about their iPhones and think about the competition out there that could unseat an iPhone.

Dave (04:50):

And right now, there isn’t a lot of it. There is a Samsung, obviously, and then beyond those two, there isn’t much. And does that mean that nothing will come up, come along someday, and unseat it? No, it doesn’t. It could, could very well happen, and it could easily happen. We don’t know I’m not in the tech world, so I don’t know what’s sitting out there that could be the next greatest thing that replaces something like an iPhone. And we think about if you think about iPhones and you think about the evolution of them, not that long ago, a company like Blackberry was the King. They were up; Apple upended them because Apple created a better product that was easier to use. And it just appealed to people. And, you know, I like to say that it’s, it’s easy enough that a four-year-old could use it.

Dave (05:39):

And it’s also easy enough that a 40-year-old could use it. So it kind of fits all those, those patterns. But the main, I guess, concept to think about is thinking about a company that can withstand competition and kind of stand above the crowd. There are lots of great examples. Buffet likes to talk a lot about Coca-Cola as a company that has a superior moat. Pepsi is a big competitor to theirs. And depending on which beverage is your choice, I’m more of a Coke person myself, but it depends on who you, who you, what you think is better. You know, there was years ago, there was that discussion about which tasted better. And Pepsi was doing all these blind taste tests. And, you know, we were showing that people were actually choosing Pepsi and then cook, cook, cook Coke, Coke made the foolish, foolish decision to try to change the recipe and try to, I guess, stand with Pepsi as far as they go.

Dave (06:41):

And it created a huge backlash. And if they continued on that path, they could have eroded their moat. And so those are all kinds of things that I guess when you’re thinking about investing in a company, you have to think about the competition out there and what kind of impact that could have to think about a company like we like to talk about a Tesla. We like to, I like to bash Tesla, but I’m not going to pass them for the moment. I’m going to talk about, I guess, think about this with Tesla. So they are the first really large company that has taken electronic vehicles to the forefront and love them or hate them. Elon Musk has certainly driven that change that’s occurring now in the auto industry. But one of the things that a lot of people that are, I guess, bearish on the company that is against investment in Tesla are concerned that right now the company has a moat, but you could argue that it’s a narrow moat because other comp competitors are stepping up to the fore to compete with them.

Dave (07:44):

For example, general motors, Ford, Volkswagen, Toyota. Those are just some of the big four companies. Then you look in China Neo has taken on, taken off. And I think there’s another company that I’m blanking on that has taken off there as well. So all those things are things that could potentially erode Tesla’s moat someday. It may not happen. And it may, it just depends, but that’s all part of investing because you have to consider the moats and have to consider the impacts of all those things. And there are different kinds of moats. So right now, we’re just talking about generalities, but I’d like to talk a little bit about maybe a few of the bigger kinds of moats that are out there. And I’m going to throw that over to Andrew. So he can chat about that a little bit

Andrew (08:30):

Before, before you do, cause I think there are, there are several types of major. I don’t know if you want to call them like not prototypes, isn’t the right word, but kind of archetypes, you know, like, like different businesses will have a similar type of muscle, like a big one, would be like a scale advantage where the bigger you get, the lower costs are when I, you know, you mentioned talking about and Pepsi one of the great moats for, for Coca-Cola outside of, you know, having a tasty beverage that has people with their preferences is they took a very different approach to the distribution part of the business. And so if you want to contrast what they did versus what Pepsi did, Coca-Cola said, instead of taking all of this expensive manufacturing in-house, we’re going to have bottles do it. And they’re going to take up these expenses.

Andrew (09:26):

We’re just going to focus on what we’re best at. So, Coca-Cola was very capital efficient, whereas Pepsi kind of, they weren’t as focused, and they were trying to dip their toes and a bunch of different things. So they tried to buy up like Frito lay and tried to get into snacks and tried to hit other areas of grocery. And so during that time, when, when buffet first bought into Coke, they just completely ran over Pepsi. Even though Pepsi was trying to do these kinds of advertising campaigns to say, Hey, logically, are our drinks better? It didn’t matter because Coca-Cola had those, those deep moats and that it goes to show how, how there can be different aspects of a moat within an entire business. So whether it’s a product like going back to the Apple thing with the iPhone, I think one of their biggest moats is their I message because I had to deal with this firsthand where I used to have an Android.

Andrew (10:22):

And if you guys use, I message, you know, when you have a group chat, everybody who’s in the group chat, as long as you have an iPhone, we get the blue box. But as soon as one person with an Android comes into the group, chat, it ruins the whole thing. And it turns, the box is green. What’s probably what the problem with that is if you’re trying to share pictures and, and they, and there’s an Android in the group, chat, the pictures come in very, very low quality because something to do with the way they’re doing that, some mess to, to include the Android ruins the picture quality. So, my family had a separate group chat away from me because I had an Android. And so eventually, of course, I had to switch over the iPhone. So I could be part of these group chats.

Andrew (11:06):

And I’m never going back right. As, as, as far as, as with the funds that are available today. So I message it is an example of something within the Apple product that gives it this competitive moat that you combine with network effects, where the more people have an iPhone, the more people use, iMessage. The more powerful that moat is because now you want to buy it to fit in and be a part of the conversation. Or you could have a distribution moat-like with Coca-Cola or some other kind of business efficiency moat. We’ve seen many of those in retail, too, where the way you’ve structured different parts of your business, from distribution to logistics, to even the way you treat employees, all can have different bearings on the final results of a business. And you could have a company like Coca-Cola that billows one of their competitors like Pepsi out of the water, even though the industry as a whole is doing well. And so you can start to have investments that do a lot better than their peers when you correctly identify the companies that have moats.

Dave (12:15):

Yeah, That’s a great example. I love the idea that you had to switch from a Samsung too; you had to come to light to be with everybody else. Yeah, that’s, that’s a great example of a, of a product that allows the company to have a competitive advantage. And it encourages the network effect because the more people that want to be involved with other people in that group chat like your family, you, you know, if that’s important to you, then you, you, you have to have the product to be part of it. And that’s, that’s where that whole network effect comes into for he also asked some ideas about maybe ways that you could measure this, or, you know, there, I guess, you know, what kinds of things can you look for in a financials you think to help give you an idea of, of a moat beyond just kind of moat of the thought experiment.

Andrew (13:07):

It’s a great question. And it’s very difficult to answer. And so I think just like you can find a unique moat for every business. You could find, not that you could find a unique metric, but you could find you could easily make the, I don’t know, it’s, it’s easy to be biased and say, Oh, because of this, then that like, it’s easy to attribute certain things. So, you know, you can look at Coca-Cola, and you could say, well, why was there, so how could you have known the amount was so great? Well, just look at their earnings. It was growing, looking at the revenues it was growing, or looking at their balance sheets. So strong, or look at this metric or that metric. And really, you could be right, or you could be wrong. I think the closest metric I would think of would be ROIC.

Andrew (13:54):

And I know we don’t want to get into the specifics of that, but even with a metric like that, that’s very strong. There are still some downsides to it. And so, you know, you want to have growth in all of these things. So really, there’s not going to be a single metric that you can use to say, Oh, well, this metric, they’re better at this metric than this company. So they have a better moat. It’s just, it’s not that easy, but what the numbers will help you do is kind of help you tell the picture of whether the moat is working. So I’ll give an example of this. I had a company I bought a couple of months ago, recommended in the Eli there. I was looking at auto insurance, and auto insurance companies are generally a very good business moat because they’re able to invest the float customers, give them premiums, and then they’re able to not only make a profit on the premiums versus the claims that they’re also able to invest it.

Andrew (14:46):

And it was a big reason why Buffett did so well because he invested in Geico, understanding the very favorable business conditions of auto insurers and how they can help shareholders. When I wanted to look at how this auto insurer was doing, I wanted to compare it to its competitors. And so, you know, even though I had the feeling and I had the idea that they were doing well, you know, you would look at the numbers behind everything looks good. It’s all going in the right direction, but you want to, you want to go a little bit deeper than that. So, in this case, I looked at the market share between them and other main competitors. And so, over the past five years, they had taken quite a bit of market share compared to some of the other ones who have fallen away.

Andrew (15:34):

So, you know, not a perfect metric, but one way to be like, look what they’re doing. And what management has been doing to push the business forward has been working for them because the industry has grown. So every business in the industry has grown, but when you compare their market shares to their competitors, this one’s doing better; this one has other metrics that also look good. And so I want to go for this one rather than that one. So that’s one example of a way that you can try to identify a moat, but just because, just like every moat’s different, the way that you’re going to interpret the numbers can be slightly different. And so where you should look in a company’s financials might be different too.

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Andrew (16:24):

You explain a little bit the concept of market share and maybe in a broad sense of how that works, so that if somebody wants to go home tomorrow and go, Hey, I like these companies in gaming. And I want to look at kind of the market share over the last few years of some of the top competitors and see how that compares. How would they do that? That’s a great question. So market share if we look at all of the gaming companies, as an example, let’s say there’s $30 billion spent in gaming every year. And if you take the top three companies and let’s say they each earn a third of that, then that would be the market share. So if there are four, the billion, they each are in like 13 billion or something, they have 33% whose market share is 33%.

Andrew (17:13):

And so there are several ways you can do it. Sometimes you’ll have kind of like researchers who will, who will put that information forward. You can sometimes do it yourself, where you can collect a list of all of the companies in that industry, and then you look at their sales numbers. You add them all up, and you compare, okay this company that’s coming in this company, this company what’s their total. And then how much does each company have? That’s another way to do it. You can go deeper and deeper and deeper because there can be different segments within different businesses, but as a general rule, that’s what you’re going to at. You want to look at the market as a whole, what’s the business I’m looking at earning now. And how does that compare to the market as a whole?

Dave (17:56):

That’s a great answer. Another ask another way that you could do that. And this is something that I’ve started trying to do recently is; when I read through a company’s proxy report, a lot of the companies will list in there a peer comparison. So when they are whistling all the different monetary benefits that management might get from the company, I will list all the competitors comparing their financials. And so, one of the things that I started doing was taking all of those companies. It could be as little as five; it could be up to 20 and doing the same kind of idea, taking the revenues from all those companies, and then comparing the company that I’m interested in and seeing their percentage. And then you could even go back for five or ten years using a really easy screen, like quick ABAs that can give you all those numbers pretty quickly.

Dave (18:51):

And you could, you could see very quickly what kinds of market share that particular company commands of that particular peer group. And even though it may not be every single company that is in, I don’t know, FinTech, but if it gives you 20 companies out of the FinTech, it’s the closest competitors of the company that you’re interested in investing in. And so that would give you a, I think, a good snapshot at least of how that company is doing against his peers. And I think that’s an easier, easy way to look at that as well.

Andrew (19:24):

Now, my turn to ask you a question, Dave. So in the scope of like trying to find a stock you buy, how high of a priority does a moat have for you and, you know, how does it relate to other things? If we find a company with a great moat, are we just going to, that’s the investment to have all these wide-moat companies, or is there moat to it?

Dave (19:46):

Oh yeah, there’s more to it. I think it depends on, so I’m not trying to hedge, but there are two ways to think about this. So there is the I’m going to wait until I find the absolute best company, and I’m going to back up the truck and throw every penny I got into the company. And that is kind of what Warren Buffett and Charlie Munger have done through a large part of their career, especially with the big investments that they’ve made for Coca Cola, American Express, Wells Fargo, Apple recently, a lot of those companies, they have thrown a lot of money into, and they have a big store of cash to do something that with. And so that’s very common and some of the bigger, the bigger investors out there that, that we really like when he’s for bride being one, in particular, he runs a very concentrated portfolio, which means that he puts a lot of energy and a lot of resources into an investment.

Dave (20:45):

So when he does it, he’s doing it with the idea that he’s buying the absolute best company he can buy. And he had his attention to hold that for a long period. So there’s that, I guess, idea of investing. And if you’re following that kind of method, then having the absolute best moat is of utmost imperative. Because if you put in all your life savings into one company and are not buying the absolute best company that will be commanding that particular market, you could have some big problems. So there’s that, then there’s the other idea where if your dollar cost averaging and you’re investing every month. You’re looking for more diversification than that kind of thing because you don’t have the absolute command of the market that Warren buffet does. I mean, when, when the guy talks about insurance, he knows his stuff.

Dave (21:40):

And so when he’s talking about an insurance company or bank or consumer product or something along those lines, the man knows his stuff. And so for him to wait into a company like Apple in the way that he has, he can do that with confidence because he has a circle of competence. And he understands that product in that market for somebody like me, who maybe wants to invest in something like, I don’t know, FinTech, for example, I don’t have the absolute command of that may for a bank or an insurance company. And so for me to back up the truck to a company like, let’s say, Square or PayPal, just as an example would be, I couldn’t do it because I don’t, I don’t know the business well enough. And I don’t know the industry well enough to determine if one of those companies has a moat over the other or has a moat wide enough to withstand any competition in the overall sector, to begin with.

Dave (22:37):

Now, if I look farther down the food chain into a different aspect, I look at something like Visa and say, yeah, they have a moat. They have a very wide moat, but then you have to consider the fact of where they are in the market, how long they’ve been in the leader, in the market, and what their price is. Because even though we’re looking for companies with huge moats, I’m still looking for a price that I can buy. That’s going to generate a good return now and into the future. And even though Visa is a fantastic company, and there’s nobody that can argue that it’s not a great company. And they’ve built a fantastic product that is, at this moment is undisputed along with MasterCard. But you have to ask the question is all that already priced into the company now.

Dave (23:22):

And so if I’m going to buy Visa, can I expect the same kind of return that maybe I could expect from PayPal and comparison? I don’t know. And that’s, that’s where that whole, it’s not just about finding the moat. It’s also finding the price that it’s at will give you the return you want, because we’ve talked about this in the past, and I’ll kind of refresh everybody’s memory. Microsoft from 2000 to about 2012 was not a great investment. It was not the juggernaut that it is now. And it, it, it kind of languished in the market for a long time. It had sideways returns and negative returns over a long period. And so if you’d bought it in 2000, it would have taken you 12 years before you’d made your money back and started earning a good return. Now, we all want to say we’re long-term holders, but I don’t know if I could hold her for 12 years.

Dave (24:14):

I mean, I have to be honest about that. And I don’t know if I could have done that, and I don’t know if anybody else could, but anyway, my point is that if you buy Visa at the wrong price and five years from now, it’s still rough. It’s only trading at 2% above where it was. You’ve made a 2% return over five years. I could have just put the money in a savings account. Well, I made a savings account, but I got to put it in a T bill or something way more conservative and probably earn more money. So there’s an opportunity cost to doing something of that. So I guess those are, I guess, some thoughts I have; I’d be curious to hear what your thoughts are, sir.

Andrew (24:49):

Well, of course, I’m going to agree with you, right? Speaking my language. I think that’s the big problem. When you talk to investors, it seems like they’re either all on the moat camp or they’re all on the price camp, and you need to be somewhere in between. And so yes, you can have a great moat, but if you’re priced to perfection, then you’re not going to; it is not going to end well for investors. And you’ve seen that over and over and over again, like you said, with Microsoft, was a great example. Cisco is another great example. They, from the last time I checked, I don’t know if they’ve even still rebounded from their 2000 peak, and all they’ve done ever since it’s grow and compound earnings and cash flows. It’s kind of funny. So again, you know, the moat will allow a company to earn and grow at higher rates than your average company, but to what extent and how much are you going to pay out for it? Because if they can’t continue to do that and you pay too high of a price, you’re not going to make a return on the stock. And that’s just the way it goes.

Dave (25:52):

Yup. You’re right about that. And you thinking further down to the idea of this I’ve, I’ve been reading through a lot of 10 Ks recently. I’ve come across some pretty darn good companies that I’ll give you a couple of examples of it. Adobe fantastic companies, ridiculous margins, awesome sales, growth, all kinds of great stuff, but they’re all expensive. And when I say expensive, I am talking about buying a thousand-dollar iPhone for $4,000. Who’s going to do that. It’s, it’s just not, it’s not, I’m not saying they’re not good investments. I am saying for me, that’s not what I want to buy. I want to buy something that has room to grow and account for any mistakes I may make in the idea that Intuit is a fantastic company and into the top of mind because it’s tax season.

Dave (26:45):

So Turbo Taxes, you know what many people use raising my hand, I use it. And it’s a great company. It’s, it’s, you know, you read through the financials, and they’re organized. They’re well laid out. They have lots of great information and share lots of details that not many companies always share. And so all those things make you for me, somebody’s like, Hey, this is, this, this company cares about me if I’m going to buy that company. And, but the simple fact of the matter is, is it just trades at a higher multiple than I want to pay. It’s just more expensive than I want to pay. And, but Adobe’s the same thing. It’s a fantastic company. It just doesn’t trade for what I will want to buy because I don’t feel like it has that long term of growth.

Dave (27:31):

And when I talk about something like that, let’s do a quickie thought experiment here. So this is something that Warren buffet throughout during the last year’s holder meeting that he had a few weeks ago in 1989, out of the top 20 companies in the S and P in the world in market cap at all. Exactly. None of them still exist in that same 20, 32 years later. So I know that’s a long time, but think about that 32 years later, not a single company is still in the top 20. So when we think about a company today, like Apple or Google or Amazon or Facebook, or any of the ones that dominate the top five or ten here in the United States, the chances that any of those are going to be here and other 20 years are slim to none. And it’s not that I think any of these are bad companies or bad investments. It’s just a simple fact the history has shown that, through time, once the companies get to a certain size, it’s hard for them to keep doubling and doubling and doubling, and Amazon and Apple may prove us wrong. It’s entirely possible, but it’s highly unlikely that all five of those are all 10 of the top companies in the STP right now will still be the same 10 in 10 years, let alone 20 years. And certainly not 30 years.

Andrew (28:51):

That’s a great point. I think a great way to wrap up the discussion on moats and, yeah, you can build a moat, but the moat has to change and evolve as the world changes. And so there are lots of businesses back in the day, they used to have moats, and those moats erode as other businesses come in and find better ways to serve the customer, have better products and services and have things that have greater performance and essentially give better value to the people who want to buy it. So yeah, you do gotta be careful that yeah, a company has a moat. Now that doesn’t mean it’s going to have the same moat even five years from now. And so that’s where the margin of safety comes in, where it’s like, Hey, you know, the stock is priced to have like the best moat in the world for the next decade.

Andrew (29:39):

Maybe I don’t want to pay that much. If they stumble a little bit, the stock is going to crash. So let me build a margin of safety into that. And you know, maybe a company doesn’t have as strong of a moat, the VAs, a bigger margin of safety, which might be a better investment because the market’s not acknowledging that they do have a pretty good Moat. And so they could have above-average growth versus another company. And so those are all things to keep in mind in addition to, you know, just the company itself and what kind of a moat it has.

Dave (30:11):

All right, folks, we’ll go with that. We are going to wrap up our conversation on boats today. I wanted to thank Sam for taking the time to send us that great question. And I hope we helped answer that question on moats. So without any further ado, I’m going to go ahead and sign us off. You guys go out there and invest with a margin of safety emphasis on the safety. Have a great week, and we’ll talk to you all next week.

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