Building Moats

Identifying the early signs of moat construction

A couple of weeks ago, I shared some notes on a presentation by Dorsey Asset Management that discussed moats. The article summarised why they matter and examined the various manifestations of structural competitive advantage. What it did not do, however, was directly touch on the topic of identifying companies that are in the process of building a moat. The article primarily focussed on identifying moats which already exist, with examples from businesses with moats that had been long established.

Perhaps this was implied. Some might suggest that reverse engineering the common traits may assist in your search for early moat detection. Nonetheless, a talented reader of Investment Talk reached out with a request to add to this particular area of discussion. If the content is quality, I am always happy to introduce new faces to the Investment Talk audience.

An investor who goes by the alias Ironside Research on Twitter, and authors the Market Beat newsletter, wrote the following article as a follow-up to my previous entry on moats. I hope enjoy it. If you do, I believe you will enjoy the rest of the work they share in their newsletter.

---

Established Moats

Moats are an interesting concept in investing. When they’re established, few doubt their presence. For example, it would take a lot to convince an investor that Google didn’t have a moat in internet search, or that Apple didn’t possess a moat with its App Store ecosystem. Costco is another company with a highly respected moat in an industry where moats are typically non-existent. Moat hunting is also a lucrative pastime. Consider the long-haul returns the companies mentioned above have generated. While the clear winner over the last 20 years has been Apple with a +1,000% total return, Costco and Google haven’t exactly been slouches.

Total Returns of Google, Apple, Costco, and the S&P 500, via Koyfin

Well, that’s cool, you might think, but everyone else already knows about those moats. While a case can be made that jumping into Google or Apple at today’s prices is still a good investment because of their moats and competitive advantages, a juicier question lurks behind the scenes: how can investors identify the next Google, Apple, or Costco?

To put it differently, how can you identify companies that are in the process of building their moat? That, as they say, is the million-dollar (perhaps billion-dollar?) question. Answers to this will, of course, be wildly divergent, but I hope to establish a working framework that investors can use to evaluate a company and its prospects. Let’s get to it.

What Makes a Moat

What makes a moat? Well, there’s a great article on Investment Talk that discusses that exact question in depth (read it here), so for this we won’t get too far into the weeds. I’ll posit a few questions that I think investors should be able to answer ‘yes’ to when evaluating a company for its moat (in no particular order of importance):

1. Does this company have brand loyalty?

   1. This can take many forms. If a company sells clothing, are people willing to buy based on the power of the logo? If a company manufactures aircraft parts does it build them to a level of quality that no other manufacturer can match?

2. Is the customer base sticky?

   1. Would it be cumbersome, expensive, or otherwise inconvenient for customers to switch to a competitor’s product? I think the most popular example of ‘sticky’ customers is banks and their depositor bases, but there are other forms of stickiness. Consider, for example, the fact that 90% of Americans live within a 10-mile drive of a Walmart (yes, that’s a real stat), which creates such convenience that shoppers are almost magnetically attracted to the stores.

3. Is the company a leader in its space?

   1. On the surface, this seems like an easy question to answer, but it is not always obvious. While you might be able to identify Coca-Cola as a beverage industry leader, it may be more difficult to determine, say, which farm equipment provider is the market leader. In some industries, market share may not always be indicative of high performance.

4. Can the company either differentiate itself or offer a differentiated product?

   1. Most people don’t care whether they buy a screw from Fastenal or Grainger. But they probably care about differentiation when buying a smartphone. For some industries (like industrial supply) there is no product differentiation—the way the companies differentiate in that business is by achieving scale. For smartphone makers, product differentiation is very important. Companies that cannot achieve either competitive or product differentiation are in a pretty tough spot, moat-wise.

5. Does management execute on what it says?

   1. Does management provide reasonable guidance and meet it? Does the company have high-quality governance and has the board ensured that management’s incentives are aligned with shareholders? Are earnings calls used to tout the latest buzzy investment theme (AI! Web3! Blockchain!)? Charlie Munger, in his only podcast appearance, said in so many words that excellent management and consistent execution were what ultimately differentiated Costco from its competition and attracted him to the company. (Note: I think that this is the most important, and most difficult to answer, question.)

There are a million other questions one could ask, but I think these five strike at the heart of what we’re looking for. A company that doesn’t check the positive box for at least three of these questions can probably be considered to have no moat.

The Moats Of Tomorrow

I’d wager if that you’re looking at companies that possess all the qualities discussed above, you’ll probably find yourself disappointed. Why? Because if you see it, so does everyone else! The market will inevitably assign a premium to stocks that it thinks enjoy a competitive advantage. Kind of by definition, then, the moats of tomorrow look like trenches or little holes in the ground today.

With that in mind, I would say this is the question investors should ask when evaluating a company: could this company at some point in the future answer yes to these questions?

It may be hard to believe, but at some point in time (even if only a brief time) Facebook could not be said to have a moat. In a nascent online world with sites like Friendster and MySpace, Facebook was just another place to put your photo and interact with other people. Its base wasn’t yet sticky. The product wasn’t super differentiated. However, a small group of investors believed that those things could change. Now, I can’t predict the future any better than you or anyone else. But I can apply those questions to companies in the market today and dig around for hidden gems.

How?

The answer is *gulp* a lot—a lot!—of reading and research.

But don’t worry—I’ll break down how you can utilize the five questions above to systematically find the answers.

1. Could this company develop brand loyalty?

   1. Clues to answer this question can be found in many places. Sometimes you are a user of the product and the obviousness of its quality or convenience just hits you in the face. Sometimes you have to look through quarterly and annual filings to find client retention metrics. If those aren’t available, you can call or email the investor relations team at most companies and ask if they’d be willing to provide any insight.

2. Could the customer base become sticky?

   1. How does the business in question conduct business with its customers? Does it sign contracts over multiple years that cannot be cancelled, or do customers renew business month-to-month or quarter-to-quarter? Is the product of particular importance to the customer? It is much easier for a company to change which company provides water for the water cooler than to change its CRM software.

3. Is the company positioning itself to become a leader in its space?

   1. Expanding partnerships, onboarding new customers, and generally retaining customers is a good indicator that a company’s offering is high quality. A good place to look would be companies that are currently not the market leader. Oftentimes these (usually smaller) companies will see their business grow at higher rates than competitors.

4. How can this company either differentiate itself or offer a differentiated product?

   1. What makes a company stand out in a particular industry? Sometimes it’s the quality of the product (Mama’s Creations, for example, has had quite the run this year on the back of a high-quality product in an otherwise commoditized industry). Sometimes the differentiation is scale and customer convenience (Costco). Whatever it is, a company may establish, that building a moat requires differentiation of some kind.

5. Does management execute on what it says?

   1. This one will require some digging. Go back and read several earnings calls and ask yourself—did the company miss or meet its targets? If they missed, were those misses addressed or glossed over? Has management consistently highlighted the same key business metrics over a long period, or are they always switching things up to highlight whatever will make them look good? Remember, as a shareholder you’re entrusting management with your money. Breaches of trust and inconsistencies should be taken seriously.

Don’t Be Discouraged

Now, the unfortunate truth: moats are hard to come by. Most companies operate in highly competitive environments where differentiation is difficult, it’s relatively easy for customers to use another product, or (sadly) have management not in full alignment with shareholder interests. But, as Charlie Munger would say, why should it be easy? A huge part of successful investing is hard work. Consider what Munger had to say regarding how to build a successful investment track record (from his appearance on the Acquired podcast, emphasis added):

Interviewer: “Charlie, if you started with Warren today and you were both 30 years old, do you think you guys would build anything close to what Berkshire is today?”.

Charlie: “The answer to that is no, we wouldn’t. We had… everybody that had unusually good results… almost everything has three things: They're very intelligent, they worked very hard, and they were very lucky. It takes all three to get them on this list of the super successful. How can you arrange to have just […] good luck? The answer is you can start early and keep trying for a long time, and maybe you'll get one or two”.

In other words, finding a company in the process of building a moat is quite difficult, but not impossible, and you shouldn’t expect it to be easy. However, with the right questions and a healthy dose of curiosity, you’ll probably end up OK in the end.

---

And so concludes another great guest post. If you enjoyed the work of

Ironside Research

be sure to give them some support over on their newsletter.

Thanks for reading,

Conor