Some notes on ‘Measuring the Moat’

Recently, was fortunate enough to come across a report by Michael Mauboussion & his team titled ‘Measuring the Moat’. Moats, as such is an interesting concept and its application in evaluating businesses was popularised by Buffett.

This is what he said more than two decades back –

What we refer to as a “moat” is what other people might call competitive advantage . . . It’s something that differentiates the company from its nearest competitors — either in service or low cost or taste or some other perceived virtue that the product possesses in the mind of the consumer versus the next best alternative . . . There are various kinds of moats. All economic moats are either widening or narrowing — even though you can’t see it.

This report builds further on that concept and explains its readers some of the factors which makes an investment attractive and unattractive.

Why is it important for us as investors? For a long term investor, his results will not be far different from that of the firm & the industry in which it operates. Hence, it is imperative to understand the underlying businesses well before committing larger sums for years. Also, the most important thing — it is fun & challenging enough to delve deeper for understanding these :)

Would recommended everyone to spend sometime thinking about what Mr. Maubossion is saying in order to improve our own lenses of evaluating things. I personally found the discussion which begin post porter’s five forces section revealing. Also, interesting was the discussion on why sometimes established incumbents loose to smaller entrants in the industry with a slightly different but efficient business models.

Some of the points which I found useful & revealing out of this report along with my interpretations of the same are:

• Asset specificity (at industry level):

Can the assets be put to use to some other purpose or are the fortunes tied to a very narrow business area? Take for example pipe manufacturing industry. Given the thin operating margin generally, high production scale is the key to lower costs and remain competitive. Also, equally important is to keep those capacities running. As a result, we generally see higher segmental concentration either in line pipes or sewage pipelines or oil & gas related pipes. Add to this, there is geographical concentration involved since pipes are generally bulky to transport over longer distances. These explains why companies witnesses wide swings in profitability regularly over the years.

As a rule in the world of business & investing, higher business (product & geography) concentration & general slowdown in the industry would only lead to intense competition amongst the participants in business which produces undifferentiated products. Hence, having cost advantages is crucial in ‘commodity’ like or average businesses.

One of the successful players in this tough industry is Ratnamani which have managed to navigate through these vicissitudes reasonably well over the years. But this is more of an exception rather than a norm.

• Production Scale:

This concept applies to both manufacturing & software products industry. Though there is a subtle difference. While production costs fall only upto a point called ‘minimum efficient scale of production’ in case of manufacturing firms, that for software products keeps on falling with each incremental user. They key is IP protection and product differentiation as only then will the excess returns stay. Customer captivity is also vital in case of software products. Important example here could be Microsoft, Android.

Another key takeaway is to look at dominating companies within fast growing industry closely. It is possible that with increase in market size, other players might achieve similar production scale advantages leading to evaporation of excess returns. Maruti of 1990’s is an example.

• Fleeting moats:

Moats give pretty strong foundation to the success an economic castle. But what if a newer entrant manages to destroy those foundations? Apple, Google destroyed branding, distribution & ecosystem advantage which Nokia enjoyed — just like Kodak. Currently, Pantanjali is attacking the establishments of Indian FMCG players. Difference between the former was technology advantage which newer entrants had. In the case of latter, how much damage Patanjali does would depend upon how deep does patanjali brand resonates with the customers, distribution reach it manages to expand and switching incentive it could provide by pricing its goods lower.

Technology companies generally have higher rate of changes and hence weaker moats, if any.. more so if areas of operations are limited / concentrated.

• Barriers to Exit:

Low investments need and non-specific assets leads to lower exit barriers and vice-versa. Telecom space in India, incidentally, suffers on both counts.

• Demand Variability:

When demand for products is highly variable, it induces excess capacity creation at peak which means when cycles moves through difficult times, there is intense rivalry amongst firms. Whenever demand is variable generally there is a lack of co-ordination amongst the participants which means pricing pressures do not easily abate during down cycle.

Cartel is difficult to sustain since given the fluctuating demand, there is an incentive strong enough to cheat.

• Stagnant Industries:

No growth or very low industries are like zero sum games. In order to make more economic profits, one needs to snatch market share away from other players which intensifies rivalry unlike in industries where economic profits are continuously rising for all the players. Hence, rivalry could be stronger here.

• Rate of change in cost:

To what extent can a new comer enter the industry and also have the advantage of lowering his costs over incumbent players such that new comer happens to have a lower cost of production. Happens with businesses dependent upon technology led upgradations (like textile, cement, telecom etc). Legacy systems becomes unproductive over relatively shorter time frame in some of these industries.

• Economies of Scope:

Lowering per unit cost of production by pursuing multiple activities in related field of operation such that activities become path dependent overtime. Some chemical companies happen to develop their business models around this concept.

In my view, this is a good enough moat especially if a player is able to gain significant market share in one or more of these products. This reduces an opportunity for competitors to replicate similar model since market size itself would not warrant such replication.

• Network Effects:

There are two types of networks (i) Radical or hub & spoke and (ii) Interactive. Interactive (naukri) is stronger than Radical (V-Mart, Walmart). Later may have scale advantages.

Another interesting discussion is on innovation & disruption. It nicely explains why it is more probable than not that incumbents would ignore / ridicule a ‘disruptor’ which only allow them times & resources to improve upon their processes to later take on incumbents.

It talks about mini-steel mills in 1970s which started with using scrap steel as raw material for finished steel. Initially their quality was not as good as that of integrated steel mills and hence their products found limited adoption, mostly into rebar segment, but their prices were competitive. Integrated steel mills did not mind to get out of those segments since any which ways much of that was low margin business for them. But this allowed mini-steel mills to prosper and overtime improve upon quality of their output and capture even more market share.

This in some ways also helps us understand why facebook paid staggering $19Bn for whatsapp. By doing this, they not only got their feet into an evolving ecosystem with an established product but also avoided the threat of future competition from it which could have meant losing billions in form of prolonged competition directly and indirectly.

There are lot of interesting stuff to learn from this beautiful work and above list is able to just provide a fraction of those learnings. It is highly recommended to spend some time going through it.