Thursday, October 27, 2016

Thoughts on Moats

Sustainability of investment returns is somewhat an obsession of mine. I love thinking through and pondering the long term competitive advantages of a business and what could undermine them. In my view, not all moats have equal impact on a business.
The concept of moat investing was something that I picked up from Warren Buffett’s references in partnership papers and the like. The notion that a business should have some defensible characteristics to preserve long term wealth is a powerful concept.  Without such defensibility, one would expect that any returns on economic capital greater than cost of capital eventually get competed away.
Many businesses that have generated long term returns on capital in excess of their cost of capital do have natural advantages. However some of these advantages are greater than others. Moats tend to erode, with some moats eroding easier and faster than others. Some moats can improve the characteristics of an underlying business better than others.

Economies of scope/scale

Economies of scale can generate significant barriers to entry in highly intensive capital operations. In mining for instance, where there is typically little to differentiate the materials that are extracted from the ground, the lowest cost producer normally has an advantage in being able to price lower, whilst maintaining the same margins as competitors. Over time, this should result in share to the lowest cost producer.
Companies such as BHP and RioTinto have sizeable scale advantages. However the introduction of newer technologies for extraction can change the economics for a given producer. Inherently, the characteristics of the underlying businesses that benefit from economies of scale are commodity businesses. They are price takers who are exposed to the forces of supply and demand. Thus the existence of a moat doesn’t really help improve the optics of the business, merely shield it somewhat from the forces that impact all players in the industry. While BHP and Rio are lowest cost producers in iron ore, both businesses have been greatly impacted by the general collapse in market demand for iron ore.
Economies of scale similarly don’t shield a business from a change in something better disrupting a marketplace. We are witnessing the steady erosion of WalMart’s moat as a more convenient, faster shopping experience through online players such as Amazon is making WalMart purchasing scale moat redundant. Shopping convenience is providing a more compelling experience than low prices to sections of the marketplace.

Regulatory

Regulatory moats can be a major source of competitive advantage, particularly if you are the beneficiary of the regulation. Utility players such as Con Edison benefit from regulated rate increases that give a measure of pricing power to businesses that are beneficiaries of regulation. However here again, most utilities provide a commodity service with little differentiation. Regulated rate increases are typically rather modest, giving a more muted measure of pricing power, rather than anything more substantial. This leads to modest rather than spectacular returns on invested capital.
Also regulations can change with political pressure. Moody’s once had one of the strongest moats. The business had a license to print money, as one of the few regulatory agencies that was given an approval to rate bonds. Organizations looking to raise debt financing had little choice but to get a rating from Moody’s or S&P if they wished to issue debt. However the financial crisis of 2007 and the subsequent public outcry has led to calls for reform, one of the consequences of which has been to open up the ratings market to new players such as Morningstar. Over time, this could lead to down pricing pressure.

Switching costs

Switching costs can be a very powerful competitive advantage, particularly in the enterprise, and if the service is core to a business and its process flows. Enterprises are loathe to make changes to services that are core to the essential functioning of their business. Peripheral, non-core functions can be more readily replaced, however core services are much more reluctantly substituted. Companies like ADP and Paychex which provide payroll services have a good customer lock because businesses don’t really want to muck up their payroll. I’d argue that database provider Oracle has an even stronger advantage as its database systems tend to be core tools underpinning the process of organizing and analyzing business data.

Network Effects

By far, my favorite moat are network effects. These are the effects that accrue when users get value or benefit from incremental users joining a platform. These businesses tend to be very powerful, both in the consumer and enterprise domain. This is primarily because the presence of a network effect helps these business become the standard.
By becoming the standard, a business with a network effect can often withstand emerging businesses that may be technically better solutions. In the battle of the video standards, betamax was a better standard than VHS, but ultimately VHS prevailed as it had established a broad network and ecosystem with hardware manufacturers and content providers.
Similarly, a network effect insulates businesses from emerging technical standards that may be better.
An even more refined and powerful implementation of a network effect is a 2 sided marketplace. A business aggregates a network of buyers and sellers, creating a flywheel effect. As more buyers come on board, that in turn attracts more sellers and vice versa. The business becomes more valuable as more buyers and more sellers come on board. Eventually, this helps create a virtual lock on a market place. Combining this with some element of switching costs, lead to business with a virtual lock on a market.
In the payments space, Visa and Mastercard have created a 2 sided marketplace at scale, aggregating both consumers to use the card, and merchants to accept it. Its a non-trivial exercise to build this globally. While bitcoin arguably represents a more innovative approach to payment security, it faces a huge burden in being able to gain significant acceptance of merchants and consumers to be a viable threat to traditional payment acceptance. In my mind, an alternate payment system faces an almost insurmountable burden to displace the payment giants.
Similarly, online shopping platforms can also develop insurmountable advantages if they become first to market in aggregating buyers and sellers in a marketplace. Its for this reason that a platform like Amazon will not be dethroned for the foreseeable future, and why Mercadolibre will be the dominant e-commerce platform in Latin America inspite of any new market entrants. Overlaying additional complementary services like payments and shipping all help to reinforce the customer lock and network effect.

Combining different moats

The ultimate business is one that combine several different moat effects to really generate solid customer lock. A network effect business that can be deployed in an area that has high switching costs should lead to outsized gains for the market leader in a vertical. Its for this reason that I like Aconex and WiseTech Global, and why I am looking to be a true business owner/partner in these emerging business.
Both provide a sticky platform in a key aspect of their respective customer’s businesses which they are loathed to switch out. When combined with a service that becomes more valuable as other industry participants join, as well as a significant first mover advantage and significant tailwinds, these business should become global icons that dominate their niches for years to come (to the extent that they don’t get acquired first).

This article was written by Financially Integrated. If you enjoyed this article, please consider subscribing to my feed.

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