Half Baked (Investing) Ideas: How Much Do Moats Really Matter?
Half Baked (Investing) Ideas: How Much Do Moats Really Matter?
If identifying a company's moat is important to an investment thesis, why do so many companies with high moats end up being lousy investments?
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Most of the financial and investing writing geared toward individual investors focuses intensely on economic moats. Businesses with a distinct, durable competitive advantage will allow them to succeed for years on end. Investors who can identify these moats will have a lot more success than those without.
Two books on my desk right now tackle this topic head-on: Pat Dorsey’s 2008 book The Little Book that Builds Wealth and Heather Brilliant’s and Elizabeth Collins’ 2014 book Why Moat Matters: The Morningstar Approach to Stock Investing. Both books do a great job explaining why investing in high-moat businesses works and how a moat can help a business stave off competition.
At the same time, though, both books are littered with companies described as having great economic moats but have been terrible investments over time.
I don’t say this to dunk on the authors. Instead, I want to focus on two points that all investors should consider when evaluating a company’s economic moat.
Moats aren’t necessarily as durable as we portend them to be in financial writing.
A durable moat doesn’t necessarily translate into shareholder returns.
Let’s examine a couple of examples of this and why investors need more than a moat to make their investments work.
Moats for fighting the last battle
Moats are portrayed as the definitive method for individual investors to build a portfolio of market-beating stocks over time. Companies that can keep competitors out of their respective sandboxes typically have greater pricing power and better returns. For individuals just starting, learning to identify a moat is crucial in securities analysis.
However, like the evolution of weaponry and military tactics, moats don’t necessarily translate to future warfare. All too often, we, as investors, focus on the moat that worked in the past and less on whether the same moat protects it from future threats.
I want to focus on two book examples: Banks and propane distributors.
Dorsey explains how the “stickiness” of deposits has given large banks a substantial advantage in generating returns over time. Brilliant and Collins specifically explain how Wells Fargo (NYSE: WFC) had built a modest moat in the banking industry thanks to its high level of low-cost deposits relative to many of its large bank peers.
(For now, let’s pretend that Wells Fargo didn’t have its fake account scandal even though it is still dealing with the legal ramifications)
In the years after the Great Recession, investors were acutely aware of credit default risk. Therefore, how the bank was capitalized played a considerable role in how investors viewed banks.
Back then, depositor flight risk wasn’t front of mind. Interest rates had been taken an undulating path down from 19% in 1981 to 2% in 2008 and effectively zero in 2014 when both books were written. This multi-decade decline meant that there was even less incentive to move money from one bank to another. Sure, you might eke out a few basis points difference from one bank to another, but within a couple of years, there was a good chance it would be a moot point.
In an environment like this, a high depositor base is a great asset and a competitive advantage. It means you can get a good return on lower-risk lending like fixed-rate mortgages and still generate a decent difference between your lending interest rate and your depositor's interest rate.
(Yes, this was a gross generalization of banking that probably has some bank investors cringing, but bear with me)
Fast-forward to today, and many investors don’t view deposits in the same lens as they did a decade ago. Higher-yield alternatives like money market accounts and certificates of deposit have real yields (the interest rate is higher than inflation) and have turned seemingly safe deposits into a flight risk if not offered adequate yields.
Businesses like Charles Schwab (NASDAQ: SCHW) spent much of 2023 dealing with “client cash sorting,” which was their fancy way of saying their depositors moved their money into higher-yielding assets like certificates of deposit and money markets. Suddenly, something viewed as a competitive strength a decade ago (high deposit rate) had become a potential cause for concern.
Similarly, I want to highlight propane distributors. Not just because Dorsey mentioned them in his book as a great example of a high-moat business. If I had started writing Misfit Alpha 10-15 years ago, I probably would have also been gushing about propane distributors. It is a business that seems custom-fitted for a profile.
A low-growth business with good-but-not-high-enough-to-encourage-compeittion returns (8%-12%)
A fragmented industry with a few roll-up specialists taking share
Delivery fees eliminated commodity price risk
Dominant positions in geographic regions lowered the risk of pricing competition
All of this was true in 2008, and some of those points still apply today. Since then, though, a few things have drastically changed.
One drastic change has been the total demand for propane. I’m not talking about for your propane grill (which, shame on you, get a charcoal grill). Most of the U.S.’ propane demand is from home heating. Over the past 20 years, total heating degree days have steadily declined, reducing overall heating demand.
At the same time, ductless heating and cooling systems were becoming much more efficient and cheaper. As a result, more and more homes are switching to electric heating sources instead of gas. In 2000, 70% of new homes had a natural gas or propane heating source. In 2020, that number had decreased to 55%. Less heating demand and a shrinking market share is an almost impossible task.
A propane distribution business can likely get by with low to no demand growth. Companies in this space have some pricing power for delivery fees. Managing a business in perpetual decline is a whole other animal.
When Dorsey wrote his book, I'm guessing he was thinking about Suburban Propane Partners (NYSE: SPH) without directly mentioning them. The company was a roll-up specialist that went public in 1996 and had thoroughly trounced the broader market in 2008.
Since then, a combination of the factors above and generous use of leverage to acquire mom-and-pop propane distributors led the company to scale back its growth-via-acquisition strategy drastically and has cut its dividend twice since 2017.
Suburban had a wide-moat business, but the water was slowly evaporating.
The takeaway here is that moats can be less durable than investors or investing writers portray them to be. We cannot take any company’s advantage for granted because they existed at one point. Often, something that was considered a moat several years ago can end up becoming a liability.
The moat may keep the Mongols out, but the water will make you sick
The second point about economic moats is probably overlooked the most: A durable moat may make a business last for decades, but that doesn’t necessarily translate to strong shareholder returns.
The first companies that come to mind in this regard are automotive manufacturers. Companies like Ford (NYSE: F) and General Motors (NYSE: GM) have been around for decades and will likely be in business decades from now, making some form of individual transport. Their brands engender deep loyalty from some of its customers that won’t likely go away.
For all of those perceived brand benefits, it isn’t something that has translated into shareholder returns. On a total return basis, shares of Ford are flat over the past 21 years.
But automotive isn’t exactly a wide-moat business. Instead, let’s focus on one sector Dorsey pointed out as having a high concentration of wide-moat businesses: media.
The thesis behind media businesses having wide moats is mainly predicated on businesses in this industry having either deep portfolios of intellectual property (Disney (NYSE: DIS) and Warner Brothers Discovery (NASDAQ: WBD) or control their distribution outlets (Comcast (NASDAQ: CMCSA)).
For all the control of their intellectual property or having control of distribution outlets, those investments haven’t translated into good returns for their investors. Over the past 30 years, investments in media have, at best, generated market-performing returns. At worst, they have been abject failures.
We can point to numerous reasons why media hasn’t succeeded over the past thirty years — disruption from streaming, poor management decisions, etc.. The more significant point is that investing in these seemingly wide-moat businesses hasn’t been a winning formula.
Don’t take this as an indictment of economic moats. They are still a valuable component of researching individual companies. That said, praying at the altar of economic moats doesn’t always translate into results for investors.
A common trope among us investing writers is to discuss seeking out the signal among the noise. The concept is a lot of superfluous information can distract us from the things that matter in investing.
There is a lot more noise out there than you think.
Even the most sound discussions of economic moats and competitive advantages may not be the signal investors seek.
I’ve said it before, and I’ll continue to say it. Individual investing has no shortcuts, checklists, or Cliff’s notes.
Keep working.