Moats Part One

Value-oriented Equity Investment Ideas for Sophisticated Investors
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MOI Members Share Their Insights on Moats
We invited our members to share their thoughts on identifying companies with
sustainable competitive advantage. We present selected responses below.
If we had to summarize the collective wisdom in just a few words, we might
echo Bryan Lawrence of Oakcliff Capital: look for high ROIC! We would
also highlight Michael van Biemas recommendation of Bruce Greenwalds
Competition Demystified as the best book on the subject of moats.

BRIAN BARES, BARES CAPITAL MANAGEMENT
The word moat is really a metaphor for competitive advantage. Our research
process attempts to parse this concept into more fundamental elements. We
undertake a Porters Five Forces analysis of each company that we consider for
our portfolio, along with other analyses of unique factors like intellectual
property, trade secrets, network effects, standardization, and customer lock-in.
We are really looking for any descriptive elements that reinforce a companys
ability to outearn its cost of capital over extended periods.
We take an unusual approach to finding wide-moat companies. Most
managers in the small-cap space use computer screening to assist in narrowing
their investment universe to a size that is more manageable. They will often
focus on factors that are evidence of a strong competitive position, like multi-
year returns on capital that are abnormally high. The problem with this
approach, in our opinion, is that once the evidence of a wide moat is published
in the companys financial statements, it is also likely that it is incorporated into
its market price. We want to search for competitive advantages that arent yet
fully actualized in quarterly or annual accounting statements. This takes a lot of
hard work. It involves being on airplanes and in rental cars and doing the
laborious fieldwork of investment idea generation. Our analysts meet with as
many companies as they can in an attempt to isolate the rare situation where a
moat is appearing or widening. By structuring our search in this manner, we
hope to build a moat around Bares Capital. It is difficult for other managers to
replicate the qualitative work in the small cap space that we have accumulated
over the last twelve years.
A good example of a successful investment of ours was a company called
Stratasys (SSYS). It had qualitative strengths that had not yet translated into
financial results when we found it. The company is the market leader in 3D
printers for prototyping and rapid manufacturing. The machines they sell are
themselves profitable, but SSYS pioneered the concept of a high-margin
consumable revenue stream for 3D printing (think inkjet cartridges for 2D
printers). SSYS came from a distant #2 position to industry pioneer 3D Systems
a decade ago to their position of dominance today. They did it by painstakingly
building a distribution network of small resellers with whom they shared a
portion of their consumable revenue. This model locked in the best sales agents
early and at a time when 3D Systems was stuck selling into an antiquated
service bureau channel. As ASPs for printers dropped, customers could afford
the machines directly and no longer needed the service bureaus. By the time 3D
Systems could sell directly to customers, SSYS had already locked in the best
distribution. This was something we recognized as a moat (and one that was
widening), and we knew that the potential for outsized future returns on capital
We are really looking for
any descriptive elements that
reinforce a companys ability
to outearn its cost of capital
over extended periods.


was high. Simple small-cap screens were not able to produce this type of
information or understanding. We had to do the hard work on the qualitative
aspects of the business ourselves.

ETHAN BERG, PRIVATE INVESTOR
What constitutes a wide-moat business?
There is the definition I learned by listening to The Grateful Dead and the
definition I learned working with Michael Porter and the firm he co-founded,
Monitor Company. Fortunately, the two definitions are remarkably similar.
For many years, The Grateful Dead was one of the most popular and
highest grossing touring bands in the United States. This is not bad for a group
whose lead guitarist was missing 2/3rds of his middle finger. Two quotes about
The Dead crystallize what is important about moats. J erry Garcias made the
observation that Our audience is like people who like licorice. Not everybody
likes licorice, but people who like licorice really like licorice. He understood
that they were not going to appeal to everyone, but the fans they did have they
were incredibly passionate. Bill Graham commented, The Grateful Dead arent
the best at what they do; they are the only ones that do what they do. They had
a distinct sound, a distinct approach to selling tickets, a distinct approach to
taping and simply a different ethos. Unless you can point to something
distinctive about a company that provides customers a specific benefit, you
should be reluctant to say it has a moat. Together, those two vignettes capture
the essence of what we hoped to achieve in each of the projects I did during the
seven years of Porter/Monitor strategy work.
So how did we think about how a company wins? Porter wrote about it in
his HBR article, What is Strategy? Companies win by either delivering a
comparable product at a lower cost or delivering more benefit at any given cost,
or both. A company outperforms rivals only if it establishes a meaningful
difference it can preserve, a durable advantage. They are not simply the best in
terms of operational excellence they are actually different. To repeat, wide moat
businesses deliver greater benefit to customers at any given cost or comparable
value at a lower cost, or both. There need to be differences in the web of
activities that the company engages in to be able to do that. A wide-moat
company exists when, for a given set of customers and needs, a company has a
unique, tailored set of reinforcing activities and/or assets that uniquely deliver
value for that given set of customers.
Our goal for clients was to identify, reinforce, or create moats. To do that
we would assess: 1) what are the possible customer segments and which ones
are attractive 2) what are the criteria by which the attractive segments purchase
and 3) to win on those criteria, how do we configure our assets and activities.
Analytically, there was a quantitative piece that was derived from intensive
survey work. There would also be a fascinating qualitative piece that resembled
cultural anthropology, which I studied as an undergraduate. The outcome was
typically a message to a CEO You can win, here is how you can win in these
areasbut you cant win everywhere. For CEOs, the decision to not try to win
everywhere could be a challenge. The decision about which segments to NOT
pursue, which growth to NOT pursue, and which activities to NOT do often
proved difficult. When Wall Street is calling for perpetual 15% growth, it is
A company outperforms
rivals only if it establishes a
meaningful difference it can
preserve, a durable
advantage. They are not
simply the best in terms of
operational excellence they
are actually different. To
repeat, wide moat businesses
deliver greater benefit to
customers at any given cost
or comparable value at a
lower cost, or both.


tough for a management team to say no we wont do this. You see companies
succumbing to this imperative all the time. I can tell you that defining moats is a
lot easier than defending or creating them.
How do you look for companies with sustainable competitive advantage?
Porters Competitive Advantage, in 592 scintillating pages, does a pretty
extensive job thoroughly cataloguing most of the variants of competitive
advantage. Ultimately, it comes down to pattern recognition, having archetypes
in mind and identifying them when you come across them. Low cost structures,
unusual brands, high customer switching costs, network effects, patents,
regulatory licenses, unique assets, and natural oligopolies always stand out.
Where to find ideas? On the one hand, very few companies have moats. On
the other hand, they are all around us. Watching my then four-year old son and
his friends obsess over Spider Man and other superheroes led me to evaluate
Marvel comics. Being a Celtics season ticket holder and following the NBA led
to Madison Square Garden (NYSE: MSG). You identify the companies with a
unique hold on customers and then wait for the price to be attractive. The Wall
Street Journal, IBD, regional newspapers, HBR, McKinsey Quarterly and other
strategy journals, business magazines, industry journals, and annual reports are
good idea starters.
Whenever I see detailed company cost data with data for companies across
industries it is intriguing, especially if you can figure out the activities/assets
that lead one company to have a lower cost structure than the others. Cents per
airline mile flown always provided a good indicator of who was guaranteed to
keep losing money. Finding high-quality data on lower cost structures that you
can tie to a structural advantage is rare, but exciting. To really flesh out the
network of activities that go into having a genuine moat, business and founder
biographies and histories are an excellent source. I have a collection of index
cards that have scribbled on them old favorites, companies that in one form or
another have a durable advantage. When they get cheap enough on the
traditional valuation metrics, I look at them more closely. When talking with a
CEO or even a salesman, ask Who in your industry scares you the most.
Success leaves clues. You can often reverse engineer who has the advantage.
For a short cut to get a quick list of advantaged companies, run a ten-year
screen on Captial IQ or similar database for companies with high ROEs each
and every year. With this list, you then ask yourself How come? Can you
identify activities or assets that help explain this persistent profitability? If so,
youve got another possible company with a durable advantage. Then you just
need to be patient to buy it right.
An experience investing in a wide-moat business or a supposedly wide-moat
business that turned out to be rather ordinary.
I invested in a beautiful piece of real estate. The property is gorgeous. It is
clearly advantaged in what they say are the three most important things in real
estate: location, location, location. Unfortunately, there were zoning and
building code quirks that made the location advantage irrelevant or at least held
it in abeyance. Lesson learned. Understand that one significant advantage, even
if its the most important thing, does not by itself constitute a moat. Consider the
related set of activities and assets.
Cents per airline mile flown
always provided a good
indicator of who was
guaranteed to keep losing
money. Finding high-quality
data on lower cost structures
that you can tie to a
structural advantage is rare,
but exciting.


This lesson came up this month in reviewing Gabriel Resources (Toronto:
GBU). If their technical reports are accurate, there is no question the asset, if
developed, will become the largest gold mine in Europe. And quite profitable, as
they will have cash costs in the lowest quartile. Coupled with a dramatic recent
price fall due to delays, there may be an opportunity there. The logic presented
by the company for moving forward is compelling. The mine is already an
environmental mess from 2000 years of mining. If they are allowed to go
forward, they will clean it up. Unemployment in Rosia Montana area is
approaching 65%. If they go forward, Gabriel will provide thousands of jobs.
Seth Klarman has a position. As the market value gets closer to the cash they
still have in the bank, it gets more intriguing. For a variety of reasons, it would
be great to be able to get comfortable enough to buy it. The hitch is that the local
permitting and politics make the mining asset worthless until they are resolved.
Even if ones analysis suggests that the mine is productive enough relative to the
current price that only a 10% probability of success would still result in
satisfactory expected returns, how does one get to the 10%? There are the
known complexities: publically known players and competing interests, national
politicians, historic Hungarian churches, local politicians, environmental
challenges, environmental groups, NGOs, even a few celebrities. Beyond the
known complexity, there is no doubt an arcane, local process that is filled with
colorful personalities, long histories and idle bureaucrats. There are also few
parcels of land they need to secure. Without the ability to handicap those
intensely local issues, how do you get from a 2% probability, to 5% or 10% ?
And when you recognize that the permits are a pre-requisite to any value being
created, it is sobering. So in this case, we can refer to a low-cost asset estimated
to have 8 million ounces of gold as a supposedly wide-moat business. Wide
moat businesses are hard to find! Even a low cost source of 8 million ounces of
gold may not be enough!

BRIAN BOYLE, BOYLE CAPITAL
There are generally four things we focus on when looking for companies with a
wide moat:
Financial Performance and Strength Does the business earn above-
average returns on capital? Does it generate excess free cash flow?
Lastly, does it employ moderate to low debt levels?
Business Track Record How long has the business been able to
generate and sustain its financial performance?
Business Outlook and Opportunities Where is the business going?
What does the landscape look like over the next 5 years?
Management What is managements track record of deploying the
excess capital? What is their ownership stake in the company?
An example today would be a company like the CME Group (Nasdaq: CME).
Its a leading derivatives exchange that trades futures contracts and options on
futures, interest rates, stock indexes, foreign exchange and commodities. CME
benefits from a network effect because they have the deepest pool of liquidity
and clients who trade on CME have capital efficiencies since the company clears
its own products and allows for product off-sets. The companys market share in
If their technical reports are
accurate, there is no question
the asset [Gabriel
Resources], if developed, will
become the largest gold mine
in Europe.


U.S. Treasuries, for instance, is 98%. In addition, volume on interest rate futures
represent approximately 20% of revenues and should benefit from increased
volatility in interest rates in the years ahead. CME is also likely to benefit from
Dodd-Frank regulatory requirements that require OTC swaps to be cleared on an
exchange versus in-house broker dealers. At 16x 2012 estimated earnings and a
dividend yield over 3%, we find the shares attractively priced.

GRAHAM CUNNINGHAM, PRIVATE INVESTOR
I dont think I could ever write anything as clear as Chapter 4 in Competition
Demystified by Bruce Greenwald. Basically, many years of stable market share
and returns on capital significantly above the cost of capital are the two things to
look for. The only companies I am invested in with these characteristics are
American Express (AXP), which I bought in May 2009, and Wal-Mart
(WMT), which I bought when it dipped below $50 per share last summer. I was
invested in Fanuc (FANUY) for a couple of years, but eventually decided that
this style was not for me. I feel much more comfortable in beaten-down cyclical
stocks or those where I feel there is some catalyst on the horizon

DANIEL GLADI, VLTAVA FUND
In theory, a wide-moat business is one that has durable competitive advantage.
This can come from various things being a low-cost producer, economies of
scale, first-mover advantage, strong brand, intangible assets, network effect,
high switching costs, and barriers to entry, among others. In actual practice,
many companies claiming to have durable competitive advantage (i.e., wide
moat) do not produce above-average returns. The first test as to whether or not
we are looking at a wide-moat business is return on capital. Mediocre return on
capital shows that this is not a wide-moat business, regardless of what
management or analysts might be saying.
If the return on capital is high, then comes a second test: high FCF. There
are many businesses with high return on capital, but with small or non-existent
free cash flow. If a company produces high accounting returns but needs to
reinvest most of its earnings back into the business in order to maintain those
earnings, then it is not a wide-moat business. Wide-moat businesses produce a
lot of free cash flow. We define free cash flow as cash that can be taken out at
the end of the year without harming the business in its current form and size.
If we see high return on capital and high free cash flow, there comes yet a
third test. How does the management allocate the cash that the company has
earned? Managements in general have two primary functions: to run the
business and to allocate the capital. The second function is critical and often
overlooked. There are many examples of companies with wide moats but run by
managements with strong ability to destroy the value they have created.
If you try to roll up a large snowball, you will not succeed if you keep
cutting it by half every two rotations. Truly wide-moat businesses must have
high returns on capital, high FCF and managements that allocate capital wisely.

CME Group (Nasdaq:
CME) benefits from a
network effect because they
have the deepest pool of
liquidity and clients who
trade on CME have capital
efficiencies since the
company clears its own
products and allows for
product off-sets.
If we see high return on
capital and high free cash
flow, there comes yet a third
test. How does the
management allocate the
cash that the company has
earned?


A few examples:
1. Mining and oil companies often claim to have competitive advantages.
In reality, although their return on capital is sometimes quite high, their free
cash flow is usually disappointing since they have to reinvest a lot into future
projects and managements often destroy value through expensive acquisitions
and/or suboptimal capital spending.
2. Sanofi (SNY) has high return on capital and high free cash flow. So
far, so good. But was the $20 billion acquisition of Genzyme the best use of
capital? I scarcely think so. It is a snowball cut in half.
3. WH Smith (London: SMWH). Boring business. But very high ROE,
very high free cash flow, with most of it regularly returned to shareholders.
Wide moats are sometimes found in unexpected and not glamorous places

MICHAEL MCKEE, MAC INVESTMENT MANAGEMENT
I immediately think about pricing power and the ability of businesses to raise
prices in excess of inflation. Wide-moat businesses have high gross margins,
high operating margins and strong operating cash flows (high and strong refer to
sustainable with the opportunity for sustainable improvements). I am a cash flow
guy at heart so this is my highest focus and the ultimate outcome of a wide-moat
business. Of course, you have to analyze the capex to maintain and capex to
grow the business and make sure it is reasonable relative to cash flow from
operations. Wide-moat businesses have strong owner earnings (operating cash
flow less capex). Analyzing owner earnings relative to the providers of capital
for the business (debt owners and equity owners) allows you to determine if you
indeed have a wide-moat business. The final challenge is to pay a reasonable
multiple of price to owner earnings. This is possible when a good business has a
short-term and fixable problem.
A success would be Danaher (DHR), which on occasion sells for a
reasonable price and represents the majority of my childrens portfolio and paid
100% of their college education.
A less-than-successful wide-moat business would be Tyco International
(TYC), which I got involved in when Dennis [Kozlowski] and Mark [Swartz]
ran the show. The company had some wide-moat businesses that ultimately
allowed it to survive, but it had a lot of baggage and a terrible balance sheet
going into a recession.

CLARK ROBERT NYE, ROBERT W. BAIRD & CO.
Generally speaking, a wide-moat business is the result of great managers
operating a business with consistently high returns on capital. The
characteristics include ongoing repeat business, either because the quality of the
product or service is superior to the competition and or there are limited
alternative choices. Examples include Apple (AAPL), Microsoft (MSFT),
Republic Services (RSG), MasterCard (MA), and Visa (V).
Other distinguishing features include high barriers to entry based on the
amount of capital needed to establish a competitive company. Examples include
Union Pacific (UNP), Norfolk Southern (NSC), and Intel (INTC).
I immediately think about
pricing power and the ability
of businesses to raise prices
in excess of inflation.


It could also be an overwhelming existing database or track record that
could not be duplicated by new competition. An example is Google (GOOG).
It could also be a protected patent or global brand with ingrained far-
reaching channels of distribution. Examples include Qualcomm (QCOM),
McDonalds (MCD), Pepsico (PEP), Merck (MRK), Pfizer (PFE), Johnson &
Johnson (J NJ ), and Abbott Laboratories (ABT).
It could also include regulatory factors where additional licensing is limited.

DAVE SATHER, SATHER FINANCIAL
Many companies qualitatively appear to have a wide moat. They may make a
great product. However, that does not guarantee a wide moat. A perfect example
might be GM. Their pickup trucks, the Corvette and Camaro are all fine
vehicles. However, GM has been a very flawed business.
Understanding this, we first focus on finding businesses that appear to have
a wide moat from a quantitative aspect. This allows us to avoid preconceived
notions about what is a good or bad business. Much like Mohnish Pabrai,
we have developed a checklist to help us with our process. The core emanated
from the book Warren Buffett and the Interpretation of Financial Statements. It
is an underrated book maybe because it is simple to read. It gives a great road
map on finding statistically wide-moat businesses.
Any business generating returns on equity and returns on capital
consistently above 15% gets our attention. We also focus on debt and pension
shortfalls. We want total long-term debt plus pension funding shortage divided
by annual net income to be less than two or three. If you also determine that
sales, cash flow and earnings are growing each year with great regularity
both as a whole and on a per share basis, it starts to become apparent that a
business may have a wide moat. In general, the numbers will tell you a story
if you let them. Often this leads us to names in the Eat em, drink em, smoke
em, go to the doctor and look good when you get there categories. The things
we look for are very basic, calculated with simple math. And that is the
problem we like to overcomplicate things.
In general, we make mistakes when we take easy concepts and make them
hard. It is a lack of discipline. We know what we are looking for but we
reach for things we want to be true whether or not the moat is really backing
the truth. We made mistakes when we found things that look good numerically,
but overestimated our circle of competency to understand that business or the
competitive landscape. We have become much better at acknowledging there is
no shame in walking away from things you dont know.
Understanding this, we stubbed our toes with Bank of America (BAC) and
Citigroup (C). Both were great franchises that were incredibly strong in their
industry. And they met our quantitative metrics. However, there was opaqueness
to their financials and their derivatives book. We obviously should have thrown
these into the too hard to understand category.
One we currently struggle with is Telefonica (TEF). We like the business
and the prospects for the long term. However, we violated our checklist on debt.
Too much debt combined with the downturn in the European markets has put
we first focus on finding
businesses that appear to
have a wide moat from a
quantitative aspect. This
allows us to avoid
preconceived notions about
what is a good or bad
business. Much like Mohnish
Pabrai, we have developed a
checklist to help us with our
process.
The characteristics include
ongoing repeat business,
either because the quality of
the product or service is
superior to the competition
and or there are limited
alternative choices.


Telefonica in a very difficult position. As such, shorter-term issues may not
allow them to succeed over the long run.

GUY SPIER, AQUAMARINE CAPITAL MANAGEMENT
Moats are at once easy to grasp and difficult to describe. In giving a definition
for pornography, U.S. Supreme Court J ustice Potter Stewart said, I know it
when I see it: The same could be said for wide-moat businesses. What makes
the search for wide moats so intriguing is that they are almost always changing,
and can come in so many different forms. For example, I never used to think of
Berkshires low cost float as a part of its moat, but it is: People in the financial
world who can consistently access cheaper money can do more just ask your
average hedge fund manager. And it was only in the last two years that I realized
that, even in mining, if you are the low cost producer, then that is also a moat.
One of the biggest fallacies I keep seeing is when someone considers all
brands as having a good moat around them. Dominant consumer brands like
McDonalds and Coca-Cola have a wide moat in all sorts of ways. But Cott
Cola, or Smart Balance (which I write about in my annual report) are brands
with hardly a moat.
In many cases, it is also hard to tell if the moat is getting wider or narrower.
With Netjets, for example, I do not believe that Warren Buffett would have
purchased the company if he did not think that the moat was widening. But I
think that most observers would agree that the moat got narrower instead. All
other things being equal, it is probably better to buy a business whose moat is
widening, rather than one which is already wide as we always have reversion
to the mean.
Of course, there is a whole added level of complexity that arises when
seeking to value a business. The key here is to appreciate a moat that is wide, or
widening, but not to pay up for it: A narrow moat in a business that is being
thrown out with the bathwater might be a good bet, just as a wide, but highly
appreciated moat (e.g. Coca Cola at the end of Goizuetas reign at KO) might
make a good teaching example, but may not make a good investment.

JOSH TARASOFF, GREENLEA LANE CAPITAL
One of my favorite moats is the volume-price-volume virtuous circle. This is
when a company achieves a cost advantage through scale and passes along its
efficiency to customers through lower prices. These lower prices attract more
customers, which further lowers the cost structure, permitting still lower prices
and attracting yet more customers. What is wonderful about this moat is that it is
not merely a defensive structure. It is a dynamic process of scaling, which
widens the advantage over competitors while growing the business.
Contrast this to my least favorite moat: customer captivity. Customer
captivity is, of course, valuable, but it also tends to be static. The mere fact that
it is difficult for customers to escape does not imply progress. Companies that
thrive as a result of having captive customers sometimes must work harder to
gain new customers, who know that they will be locked in. Such companies also
I never used to think of
Berkshires low cost float as
a part of its moat, but it is:
People in the financial world
who can consistently access
cheaper money can do more
just ask your average
hedge fund manager. And it
was only in the last two years
that I realized that, even in
mining, if you are the low
cost producer, then that is
also a moat.
One of my favorite moats is
the volume-price-volume
virtuous circle. This is when
a company achieves a cost
advantage through scale and
passes along its efficiency to
customers through lower
prices.


may fall into the trap of complacency, because the immediate effects of
providing a poor customer experience may be minimal.

DAVID WOLTERS, ING
I will let Warren Buffett talk about wide moats: an economic franchise arises
from a product or service that:
1. is needed or desired
2. is thought by its customers to have no close substitute
3. is not subject to price regulation
The existence of all three conditions will be demonstrated by a companys
ability to regularly price its product or service aggressively and thereby to earn
high rates of return on capital. (Warren Buffett, 1991)
Example: Sees Candies
Sees has a one-of-a-kind product personality produced by a combination of
its candys delicious taste and moderate price, the companys total control of the
distribution process, and the exceptional service provided by store employees.
(Warren Buffet, 1986)
Example: Red Bull
Red Bull is one of the most popular energy drinks in the world. It was founded
in 1984 by Dietrich Mateschitz. Red Bull sells four billion cans each year and
dominates its main competitors Monster and Rockstar with 40% market share.
Red Bull has a presence in more than 160 countries around the world. Red Bull
spends 30-40% of revenue on marketing. Revenue in 2006: $3.7 billion; revenue
in 2010: $5.1 billion.
The views expressed above do not necessarily reflect the views of the firms with
which the authors are affiliated.
Red Bull is one of the most
popular energy drinks in the
world. It was founded in
1984 by Dietrich Mateschitz.
Red Bull sells four billion
cans each year and
dominates its main
competitors Monster and
Rockstar with 40% market
share.

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Value-oriented Equity Investment Ideas for Sophisticated Investors

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