Economic Moats Matter More Than Ever
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“What we’re trying to find is a business that, for one reason or another — it can be because it’s the low-cost producer in some area, it can be because it has a natural franchise because of surface capabilities, it could be because of its position in the consumers’ mind, it can be because of a technological advantage, or any kind of reason at all, that it has this moat around it.”
Like the waterways that protect castles, economic moats surround a company’s profits and market share, shielding them from external forces that can range from inflation to war to recessions.
On top of that, economic moats can act as a source of growth.
For those moats to exist, as Buffett stated, the company must build a unique advantage over its competitors. Let’s take a look at how those advantages are formed.
Barriers to Entry
Can you guess one of the top reasons people give for not starting a business?Money.
Money is a classic barrier to starting a business, which is also known as a barrier to entry. Barriers to entry are obstacles you need to overcome in order to start a business in any given industry.
A good example is a utility company.
Could I start a utility company right now?
Not without a whole lot more money than I can get my hands on. Plus, there is a lot of technical expertise that goes into running a power plant.
But what about something smaller than a utility plant, like a barbecue restaurant?
I love to barbecue and can make a mean brisket, and it would cost a whole lot less money to start than a utility plant.
Let’s say I open up Keith’s House of Meat and that things initially are working out.
Then one day, a new barbecue chain opens right down the road.
Will my customers stick with me, or will they buy from the joint down the street?
That all depends on the loyalty of my customers.
As the diagram I shared earlier shows, brand loyalty can be a key ingredient in protecting my barbecue restaurant.
If I’m able to offer award-winning ribs, work with GrubHub to get my food delivered around my local area, and have competitive prices, I’ve created reasons why people would choose my offerings over a competitor’s.
The more unique my products or services, the more likely I am to maintain and grow my customer base.
The Four Ps of Marketing
Every product or service bought and sold is evaluated by customers based on the four Ps of marketing:- Price — Is it cheaper than the competition?
- Promotion — Am I aware of it more than the competition?
- Product — Does it do or provide something others cannot?
- Place — Is it available when and where I need it?
And with that in mind, I want to show you what it looks like when you don’t have a moat around your products and services.
The Zoom Case Study
What is it that makes Zoom Video Communications Inc. (ZM) unique?When the pandemic started, Zoom made it easy for teams to stay connected. It seemed as if everyone was using it, so even if your company didn’t, you would still need to download Zoom to have a meeting with someone outside of your organization.
But as more companies have started to adopt hybrid work approaches that will persist beyond the pandemic, Zoom is losing its edge because its idea of connecting businesspeople through video doesn’t have a moat around it.
Think about the messaging service Slack. Not only can you instantly message someone, but you can connect with someone on a video call or an audio call in seconds. A worker may use Slack throughout the entire day, whereas they may only use Zoom a handful of times throughout the week for something that is scheduled.
Trading at $559 on Oct. 16, 2020, Zoom had a good run, but people are now questioning what’s next for the company as it doesn’t have a moat.
Zoom is now trading below $85 per share.
Now that you have an example of what can happen when a company doesn’t have a moat, I want to show you a company that does have a moat.
Finding Moats Today
Companies can and do grow during recessions.Many position themselves for explosive performance on the other side of downturns.
Just look at Apple (AAPL).
You know when the iPhone first came out? 2007.
Guess when the market high was before the Great Recession? 2007.
Apple built itself into one of the strongest, most well-respected companies in the world through innovation, supply chain intelligence, and strategic branding.
Scanning the market today, what companies fit this bill?
A good example is SMART Global Holdings Inc. (SGH).
This semiconductor company has a moat with its advanced technology and hyper-specific applications, providing managed services for an AI supercomputer for Meta Platforms Inc. (FB) that is now the fastest and largest supercomputer in the world, according to SMART’s April 5 financial presentation.
In 2021 SMART also acquired Cree LED, a specialty lighting company (which can include things like lighting for indoor sports venues), and nearly a quarter of SMART’s revenue now comes from its Advanced Lighting segment.
This semiconductor stock is in the Yellow Zone while many others float in a sea of red.
What I also like about this company is its five-year average growth of 22.94%, its minimal debt, and its free cash flow (operating cash after expenditures) of $112 million.
It’s a business without a ton of debt and enough cash and vision to seize upon the opportunities created by a possible recession.
We’re past high-growth venture capital firms that take years to turn a profit. Investors want returns and they want them now.
That’s why I’m focused more on cash generated by a company now instead of in the future.
While dividends and buybacks are nice, I don’t necessarily need the company to spend the money on me if it can get better returns through internal investments.
Are there any companies in your portfolio that have a strong moat? Would you like us to analyze the moats of other companies? Let me know here.