Five Kinds of Moat

Quality Investing

Samuel Lee 13.02.2014
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A version of this article was published in the October 2013 issue of Morningstar ETFInvestor.

The notion of the economic moat is central to Warren Buffett’s investing philosophy. Moats enable a company to main high returns on invested capital for a long time. Morningstar defines five common sources of moats. Each can be matched up with a significant stock purchase by Buffett.

1. Efficient scale, another way of saying natural monopoly. A natural monopoly exists when a market is most efficiently served by a single firm. Large economies of scale and high fixed capital expenditures usually lead to natural monopolies. Examples include regulated utilities, newspapers, railroads, and pipelines. In 2010 Buffett acquired railroad Burlington Northern Santa Fe.

2. High switching costs. Enterprise database software and services is a quintessential case. Migrating between systems is fiendishly complex and costly and knocks out essential services in the meantime. Buffett bought about US$11 billion of IBM (IBM, listed in the US) shares in 2011.

3 Cost advantage, being able to sell goods and products more cheaply than competitors. It’s similar to efficient scale, but it can arise from a variety of factors. Wal-Mart (WMT, listed in the US), for example, owes its cost advantage to a culture that encourages laser-like focus on cost control and prudent capital allocation, a well-oiled logistics machine, and its ability to squeeze favorable terms from its suppliers and labor. Wal-Mart has been a Berkshire Hathaway holding since 2005.

4. Intangible assets, which can be split into government licenses and brands.

a. Government licenses are special rights granted by the government. The most common is the patent, a government-granted monopoly on an invention. Licensing can take the form of special designations, such as the one nationally recognized statistical rating organizations enjoy. Credit ratings from “big three” NRSROs—Moody’s, Standard & Poor’s, and Fitch— are written into countless contracts, regulations, and investment mandates. Even though many sophisticated investors ignore the ratings, preferring market-based measures like CDS spreads, nearly all bond issuers buy ratings. The big three effectively act as toll-keepers to the bond markets. Buffett bought Moody’s (MCO, listed in the US) in 2000 but has been gradually liquidating his stake since the financial crisis.

b. Brands are product identities, forged by social proof and lots and lots of advertising. Owing to quirks in the brain, shoppers will pay a premium for branded products. Coca Cola’s (KO, listed in the US) main product is nothing more than carbonated sugar water, yet Coca-Cola can sell it at fat margins because of omnipresent advertising that’s established what Buffett calls “share of mind.” Buffett first bought Coca-Cola in 1988 and has never sold a share.

5. Network effects, which make a service or product more valuable the greater the number of people using them. Credit-card payment systems are a classic example. Visa (V, listed in the US), MasterCard (MA, listed in the US), and American Express (AXP, listed in the US) all have a critical mass of merchants and users in their ecosystems, creating virtuous, self-sustaining cycles that are all but impossible for interlopers to disrupt. Buffett famously bought American Express in 1963 during the Salad Oil Scandal and has held onto shares since.

Few companies actually end up realizing high returns on capital over multi-decade spans. Charlie Munger observes that “In the U.S., a person or institution with almost all wealth invested, long-term, in just three fine domestic corporations, is securely rich.” He claims most of Berkshire’s value was created by 10 good ideas. The real trick is identifying such ideas and sticking with them.




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Samuel Lee  Samuel Lee is an ETF strategist with Morningstar and editor of Morningstar ETFInvestor

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