Everyone talks about “moats” but almost no one talks about how moats change. Moats get a little bit wider or narrower every day. A widening moat is even more valuable than a wide moat. A moat’s direction is more important than its width. Why? A widening moat implies longevity. It’s one thing to have high returns on equity. Plenty of businesses do. Long-term investors care about how much capital a business can invest at a high rate and for how long.
Nice post Matt! As investors sometimes we get too hyper focused on our DCF models and I think all of us would be better off sitting back and thinking hard about ROIC and if our portfolio companies moat is improving or not; which funny enough would probably lead to more accurate DCF models
Dec 21, 2023·edited Dec 21, 2023Liked by Matt Franz
This is such a great point. Few investors monitor their companies' moats. Also, it's great to see you mention some names I haven't heard of. It's best to buy a company before everyone touting its moat makes the multiple go up.
Examples from my side:
- Eurofins Scientific (allow me to borrow some of your points): 1. Consolidation allows them to be a cost leader; 2. The cost of their product is not material to customers' costs; 3. Their systems are integrated with their customers' systems.
- Progressive: 1. Low cost, thanks to accurate risk pricing, thanks to rigorous data analysis. However these days everyone and their brother is getting into what I think is the same thing ("AI", "data analytics", whatever you want to call it); 2. They specialize in the "high-risk drivers" niche. Niches tend to be "moaty", and if you dominate them (I'm not sure to what extent that's the case for Progressive), how are your competitors going to get the data to try and price insurance in that niche?
- Amazon and Costco are said to have a cost moat, but I think PDD/Temu's C2M model has a cost advantage vs both. And vs Alibaba.
- Apple (esp. in its early days) is an example of a "product lead" moat. So is Evolution Gaming. I don't think a product lead is easy to maintain in the long run. Evolution's size could allow them to add a cost moat, but they don't, so you're starting to see growing competition with ever more funds to narrow that product lead moat.
- Industry-wide underinvestment/attrition is a widening moat for the remaining suppliers (at least until prices rise and incent new capacity). Examples: copper mines, oil fields, offshore drilling rigs, ...
This reminds me of what Warren talks about in the book "The Money Masters", basically taking the PPE and comparing it to the EBIT to see the strength or customer loyalty of the companies. One way of evaluating the moat of a company
EBIT/PP&E is a good way to gauge return on tangible capital. Greenblatt used EBIT/(Net Working Capital + PP&E) in his Magic Formula. It's a good metric to use for identifying businesses with moats. I am not sure it tells you much about the direction of the moat though. Costco could drastically increase its ROE by increasing margins a few points. While that would be good for short-term profits, it would narrow its moat. Similarly a company that under-invests in R&D will post a higher ROE (relative to what it should earn) as it loses ground to competitors.
Nice post Matt! As investors sometimes we get too hyper focused on our DCF models and I think all of us would be better off sitting back and thinking hard about ROIC and if our portfolio companies moat is improving or not; which funny enough would probably lead to more accurate DCF models
Well said!
This is such a great point. Few investors monitor their companies' moats. Also, it's great to see you mention some names I haven't heard of. It's best to buy a company before everyone touting its moat makes the multiple go up.
Examples from my side:
- Eurofins Scientific (allow me to borrow some of your points): 1. Consolidation allows them to be a cost leader; 2. The cost of their product is not material to customers' costs; 3. Their systems are integrated with their customers' systems.
- Progressive: 1. Low cost, thanks to accurate risk pricing, thanks to rigorous data analysis. However these days everyone and their brother is getting into what I think is the same thing ("AI", "data analytics", whatever you want to call it); 2. They specialize in the "high-risk drivers" niche. Niches tend to be "moaty", and if you dominate them (I'm not sure to what extent that's the case for Progressive), how are your competitors going to get the data to try and price insurance in that niche?
- Amazon and Costco are said to have a cost moat, but I think PDD/Temu's C2M model has a cost advantage vs both. And vs Alibaba.
- Apple (esp. in its early days) is an example of a "product lead" moat. So is Evolution Gaming. I don't think a product lead is easy to maintain in the long run. Evolution's size could allow them to add a cost moat, but they don't, so you're starting to see growing competition with ever more funds to narrow that product lead moat.
- Industry-wide underinvestment/attrition is a widening moat for the remaining suppliers (at least until prices rise and incent new capacity). Examples: copper mines, oil fields, offshore drilling rigs, ...
Great note on the essencial thing to understand a business, as prerequisit for any valuation attemp.
Thanks Luis!
This reminds me of what Warren talks about in the book "The Money Masters", basically taking the PPE and comparing it to the EBIT to see the strength or customer loyalty of the companies. One way of evaluating the moat of a company
EBIT/PP&E is a good way to gauge return on tangible capital. Greenblatt used EBIT/(Net Working Capital + PP&E) in his Magic Formula. It's a good metric to use for identifying businesses with moats. I am not sure it tells you much about the direction of the moat though. Costco could drastically increase its ROE by increasing margins a few points. While that would be good for short-term profits, it would narrow its moat. Similarly a company that under-invests in R&D will post a higher ROE (relative to what it should earn) as it loses ground to competitors.
Enjoyed this.
Thank you for writing and posting this wonderful article!