For investors that buy stocks in quality companies, Pat Dorsey is the go to man. He was the Director of Equity Research for Morningstar and was instrumental in the development of Morningstar’s economic moat ratings, as well as the methodology behind Morningstar’s framework for analysing competitive advantage.
Most people associate Warren Buffet with economic moats. Buffett popularised investing in high quality companies. But if you want to understand what a high quality company is, you need to read the work of Pat Dorsey. He is simply brilliant!
This post is dedicated to Pat Dorsey. Below, I have mapped out 4 different types of Moats Pat Dorsey talks about in his brilliant book The Little Book That Builds Wealth. I have also included some of my own commentary and examples of companies possessing the various moats.
What Is An Economic Moat ?
Rather than define what an economic moat is which I have already done previously, I will describe it as Pat does in one of his presentations.
In the capitalistic society we live in, a company earnings high profits will attract competition to its industry. More completion leads to lower profits and many companies earn average returns over time. But, a small minority of companies enjoy many years of high returns on capital.
How? By creating structural competitive advantages, or economic moats.
The four different types of economic moats discussed in this post are Intangible, Switching Costs, Network Effects, Cost Advantages.
Intangible Assets are an economic moat if a company can charge premium prices for their product. Three times of intangible assets that lead to moats are Brands, Patents, Regulatory Approvals.
Brands allow companies to charge a premium price without the consumer switching to a substitute product. Brands can lower search costs, create positional value or confer legitimacy.
RB is a company with some of the strongest brands. Look at Dettol for instance. The price of Detail is 5x the price of a plain ordinary antiseptic but consumers always prefer Dettol. RB with their products lowers search costs. Consumers instantly recognise their products and would rather pick them up instead of going on a mad hunt and searching around for the next best. Coca Cola is another good example of this.
Tiffanys is another great example of a brand. It can charge much higher than other jewellers but people always want that blue tiffanys box. Heck, I am frugal and I bought a Tiffanys necklace for my girlfriend. This just shows you the power of their brand – it creates positional value.
Moodys has an economic moat by conferring legitimacy. Moodys rates different kinds of bonds / debt instruments. Heck I could do what Moody’s does. It is simple enough. But nobody would trust my rating. On the other hand everyone trusts a Moodys bond rating.
Patents are another intangible moat. There are in essence legal monopolies. This is why pharma companies can charge high prices as consumers have no alternative. 3M is another company with a vast array of patents and pricing power to boot.
Regulatory approvals is a third type of intangible asset that leads to a moat. National Grid is a good example of this where it runs a monopoly on the gas and electricity transmission networks in certain parts of the UK.
Water companies are another good example as they are often monopolies within certain jurisdictions.
But economic moats via regulatory approvals are becoming weaker as certain approvals are coming along with conditions such as a company is only allowed to charge X amount.
Switching Cost in an economic moat if cost to switch from a company products to another company is high.
A good example is Intuit with their accountancy packages. Since an accountancy package is ingrained in a company back end systems, it very costly and time consuming to change to a different accountancy package supplier.
Oracle is another example of a company that has a high switching costs. Its products are deep routed into customer businesses processes. But there is an argument that cloud computing will affect Oracles moat.
Network Effect is an economic moat if value of product or service increases with no of users.
Visa and Mastercard are great examples of this as seen by a previous post.
Ebay is another very good example. It controls 85% of US auction market. The more sellers they are, the more buyers come..and more buyers bring even more sellers and the circle continues. It gained traction by being the first mover as with most companies which have a network effect.
Social Media companies are another great example of network effects. Once enough users are on board, growth goes stratospheric and it is very hard for a competitor to displace the incumbent. Just look at Facebook and how it has performed over time.
Cost Advantage Is an economic moat if the company relative size is bigger than that of the competition and it can sustain lower cost than competition.
Examples of companies with Cost advantage moats
Sky Plc – It is a pay tv service provider. Due to its scale and reach, it can acquire high quality content by paying more and then spreading this cost across a large number of fixed contract customers. A competitor cannot easily dislodge Skys position although you can argue Netflix is gaining traction fast.
UPS – The biggest door-to-door package delivery service. Has a dense delivery network. Due to high fixed costs, new entrants are scared to enter the market. UPS can offer lower prices per parcel as the extra parcel is being delivered via an existing delivery route. An extra parcel is highly profitable as fixed costs already covered.
There you go. A quick glimpse of Pat Dorsey’s moats with examples to boot. Hope you now have a better understanding of the different types of competitive advantages out there.
If you are interested in high quality companies with string economic moats, have a look at my stock list.