In the past week on social media, I ended up in an interesting debate (with investor and shareholder activist Albie Cilliers, no less) about the definition of a moat. This is one of the most important concepts in investing, as determining the size and strength of a moat is key to arriving at a view on valuation.
Two companies can offer similar growth rates in their earnings, yet trade at vastly different earnings multiples. Assuming they overlap on regional and sectoral exposures, the likeliest explanation for the differential in valuation would then be the extent of the moat.
When earnings can be defended successfully and withstand future sources of disruption, investors are willing to pay more per unit of earnings. Naturally, the dream is to find a surprising moat and pay a cheap price for it before everyone figures out how valuable it is. Easier said than done.
The company that sparked the debate is Altron, a multi-platform technology group that has been building some of its businesses (such as HealthTech) for decades. In my view, the extent to which a platform has become embedded in a technology ecosystem is a moat. But narrower definitions of the concept tend to focus only on such elements as long-term pricing power, which isn’t the same thing.
This definition stems from one of Warren Buffett’s many helpful heuristics, in which he argued that a company’s ability to raise prices without losing customers is a clear indication of a moat. He’s right, of course, but it’s not the only way to assess a moat.
In the tech sector, I would argue that the embeddedness of a product in a particular ecosystem is a source of moat. No company is ever immune to disruption (in tech or otherwise), but it’s much harder to displace a tech company that has extensive integrations, customer relationships and compliance certifications in place.
It’s a bit like building a jigsaw puzzle: it only looks good once all the pieces are in place.
This isn’t the same as network effects, where an ecosystem becomes more valuable as it gains users (such as a social media platform, or payment rails like Visa/Mastercard). Ecosystem embeddedness is a measure of how difficult it has been to build the platform over years and even decades. It indicates the defensiveness of an existing revenue stream, rather than a measure of how that stream can grow over time. A moat around what you have today is far better than no moat at all.
On that note, this doesn’t mean that difficult businesses are immune to disruption. A moat can be drained surprisingly quickly by a significant improvement in technology, or a change in regulation that creates new customer needs.
Just ask the legacy banks, which relied on a moat built around systems complexity, regulatory hurdles and perhaps most of all, switching costs
Just ask the legacy banks, which relied on a moat built around systems complexity, regulatory hurdles and perhaps most of all, switching costs. It’s a pain to change your bank account and you’ll only do it if a competitor offers significant value. But such a competitor emerged in the form of Capitec, which built a sustainable cost advantage that allowed it to outprice the competition.
As it turns out, it’s not always about increasing prices over time without losing customers. It’s about using technology to generate better profits than competitors and at lower prices.
With Capitec enjoying 58% market share among customers between the ages of 18 and 35, the great irony is that Capitec’s moat is now based on a combination of cost advantage and high switching costs, the exact factor that it overcame when it disrupted the banking sector.
As the world changes, our understanding of moats should also be refined over time. Recent years demonstrated that a traditional source of pricing power — the strength of a consumer brand — is vulnerable. Iconic fast-moving consumer goods brands such as Nike and Lululemon are cautionary tales of how easily a brand can alienate customers and damage its distribution networks.
Having been burnt myself, I now put limited weight on brand strength in my analysis of a moat. I care far more about other sources of pricing power, especially structural cost advantages. I also value the embeddedness of a particular ecosystem and how long it took to get there, which is the point around some of Altron’s platforms that sparked this debate. My thesis is that if something was quick to build, it’s probably quick to replace. Conversely, there’s value in having gone through years of pain to build something.
Alas, there’s no such thing as a perfect moat. This is why stocks that are priced for perfection are so dangerous. That’s something that Buffett would certainly agree on as well.
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