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Durable Competitive Advantages: Using Economic Moats to Improve Investment Returns. Pat Dorsey, CFA Director of Equity Research. Agenda. Our Approach to Competitive Analysis What is an Economic Moat What’s Not Where Morningstar Finds Moats Why Moats Matter
×Switching Costs: Do the costs – in time or money – of switching to a competing product/service outweigh the benefits?
Size / Dominant Market Share: High market share does not give a firm a moat. (Ask Compaq – or GM.) In fact, market share may be irrelevant – bigger is not necessarily better.
Technology: What one smart engineer can invent, another can improve upon. (Exception: Creating a standard that’s widely adopted.)
Easily-replicable cost advantages (lean manufacturing, outsourcing.)
Hot Products: Krispy Kreme, Tommy Hilfiger, Crocs, Iomega, etc.
Can generate high returns on capital for a short period of time, but sustainable returns are what make a moat.
Moats add intrinsic value!
A company that is likely to compound cash flow internally for many years is worth more today than a company which isn’t.
Wide Economic Moat
Narrow Economic Moat
No Economic Moat
When comparing two companies with similar growth rates, returns on capital, and reinvestment needs, the company with the moat has a higher intrinsic value.
Underestimating a moat results in opportunity cost, while overestimating a moat can cause you to pay for value creation which never materializes.
Some fast-growing companies are worth the premium, because the excess returns are more likely to persist. If a firm has a wide moat that will allow it to reinvest cash flow at a high rate of return for many years, what looks expensive may actually be quite a bargain.
“Time is the friend of the wonderful business, affording it the opportunity to reinvest incremental capital at favorable rates and increase the value of the enterprise. Over time, the price you paid for a terrific company looks cheaper and cheaper. For the inferior business at the cheap price, time may turn out to be the fell destroyer.“
– Bob Goldfarb, Sequoia Fund
Moats enforce investment discipline.
High returns on capital will always be competed away – eventually.
For most companies (and their investors), the regression to the mean is fast and painful.
But a few generate excess returns for many years, and moats give us an analytical framework for selecting them.
Companies with moats have greater resilience.
If a firm can fall back on a structural competitive advantage, it’s more likely to recover from temporary troubles.
This is a great psychological backstop for the investor who’s buying when everyone else is screaming “sell!”
If you’re confident in the moat, it’s easier to average down if you initiate a position too early.
Returns through 9/18/2009 * Annualized returns Source: Morningstar