Pat Dorsey runs “Dorsey Asset Management” with a deep emphasis on investing in companies with competitive moats. He isn’t the first asset manager to use the concept of "moat", but he does have a successful track record of using this concept to bring value to his clients. In this article we build on his writings to develop our own framework for identifying companies more likely to stay ahead of their competition. We then apply this framework to the car industry in another post.
Moats 101 - Four Types of Moats
Moats become important when a company discovers a highly profitable investment. That investment might be a new product, or an improvement off an existing product. Competitors will obviously want to profit off this same investment. Moats make it harder for competitors to flood supply and bid down the price of the new investment. Moats provide a longer time horizon for invest at a higher rate of return on invested capital (ROIC).
We group moats into five categories in order of their strength today.
1. Network Effects
Network effects (NE) exist when the product or service increases in value as the number of users expands. Visa has a powerful NE because it is everywhere you want to be. NEs are maintained by subsidizing one side of the network (Adobe, Uber) and driving user engagement (Facebook), but can be at risk if pricing power is abused (Bloomberg), or the user experience degrades (MySpace, Orkut).
NEs can lead to rapid adoption rates as depicted by the "S-Curve" below. The trigger is typically a fundamentally new technology powering a product that has network effects. When combined these ingredients can create “cliff effects” and “spring loading” … two mental models Charlie Munger considers before making investments.
NEs arguably provide some of the most powerful moats, but that power can also work in reverse if the network starts to unwind. The implication is that NEs can cause the world to change more rapidly than humans are accustomed to comprehending. Few people could have imagined the speed at which humans adopted cars, electricity, telephones, mobile phones, and social networks.
The lessor known rejection curve moves just as quickly. It is the inverse of the adoption rates depicted above. When was the last time you bought a CD or a cell phone with buttons for keys? These products had network effects because society had become accustomed to using them. CD players were included in new cars. Most adults needed to own a cheap cell phone because it became an expectation that we be reachable at anytime. Then along came streaming music and the Iphone. In less than 5 years, CD and Blackberries sales were near zero.
2. Switching Costs
Costs to switching can include money, time, and risk and tend to protect incumbents. Mr Dorsey differentiates between business to business (B2B) and business to consumer (B2C).
Business to business switching costs tend to be more prevalent than business to consumer because business uses of 3rd party products can become much more complex than that of individuals. This is particular true for high benefit / cost ratio services like software (Oracle, Workiva). However, individual switching costs can be powerful as well.
Pat Dorsey doesn’t mentioned this, but we believe consumers are experiencing a rise in switching costs. Today, consumers face switching costs when required to learn a new skill (Apple vs Microsoft Windows), connect using new different social networks (Facebook to Twitter), re-create automated tools (Amazon buying habits and AWS), and rebuild neural networks (a powerful machine learning model) by switching to new personalized AI services like Amazon Alexa and Twitter Feeds.
Brands can create positional value (Rolex), confer legitimacy (Moody’s), and/or lower search costs (Budweiser). All three "brands" work differently and may have change in strength over time. Today the most powerful brands seem to be positional brands while those based on search costs are the weakest:
3.1 Positional brands like Rolex are entirely dependent on arbitrary social views. Persistence of views is therefore critical for positional brands to retain value. Positional brands are arguably the strongest because social signals of success are very slow moving. Rolex may not produce the best watches in the world, but everyone knows Rolex and it’s hard to shake the signal which relies more on barrier to entry (high cost) than functionality.
3.2 Legitimacy brands like Moody's are usually grounded in objective reality more than positional brands, making them more subject to potentially risky events. For example, Moody’s took a hit after the Financial Crisis for rating subprime mortgage bonds AAA.
3.3. Search cost brands like Budweiser are the weakest because the internet has made research and information dissemination very cheap. Warren Buffett’s long time holding Kraft-Heinz has been suffering for several years because it’s size no longer gives it an an advertising edge. Amazon stars and comments command more influence over consumer preferences than recognizing labels from TV commercials.
4 Legal Barriers
Legal Monopolies, Patents, Licenses provide moats dependent on some degree of explicit government involvement. The strongest of these
4.1 Legal Monopolies like utility companies typically include natural monopolies that are regulated by the government to prevent exceedingly high profits and to ensure equal and safe access (ex. Local water supplier). These are powerful and can lead to exceedingly high profits when governments fail to properly regulate them such as Fannie Mae and Freddie Mac during the housing bubble.
4.2 Patents like Pfizer's Epipen are legal rights to ownership of a particular technology. Patents can be very valuable and serve as deterrents, but are not full proof as they can be expensive to defend in court and may not apply to slight variants. This makes companies dependent on patents very hard.
4.3 Licenses like those given to banks are granted by governments conveying the rights to engage in certain activities. The value of a license depends on how hard it is to get the license.
5. Cost Advantages
Cost advantages can be created by economies of scale, superior processes, and niche markets.
5.1 Economies of Scale are the most well known and arguably create the most powerful cost advantage type moat. However, improved access to capital markets and cheap borrowing costs have made it easier to bring large and international production and distribution processes to scale. Size was once a much bigger factor in assessing the value of big commodity producers like oil companies and manufacturers. New technologies such as 3D printing could make scale an even weaker moat.
5.2 Superior processes and niche markets may also provide moats, but in order to do so they need to be very difficult to replicate. This requires secrecy or access to some special ingredient that competitors can’t get their hands on. A secret recipe is the classic example, and exists in many industries today besides just food such as chemical products. Some businesses avoid creating patents and opt instead for secrecy because patents require articulating exactly what you are doing and making that information public. Special ingredients can be anything, but few examples exist. One might be a charismatic leader or superior culture. However, these “ingredients” would need to be highly persistent overtime in order to really qualify as a moat...and are highly subjective.
We hope you find our thoughts on competitive moats insightful. Feel free to check out our followup post where we apply this framework to the automobile market.