With a technical recession, an ongoing energy crisis, and high inflation and interest rates, the investing world may seem terrifying to South African investors.
However, world-renowned value investors say picking companies that will perform well during tough economic times comes down to a key attribute: a moat.
Billionaires like Warren Buffet and Bill Ackman have long touted the advantages of picking companies with moats.
A company’s “moat” is its intrinsic, durable competitive advantage that sets it apart from its competitors. This advantage allows a company to generate consistent profits over the long term – even during challenging economic times.
Superinvestor Mohnish Pabrai said this attribute separates companies like Coca-Cola, Apple, and Google from their competitors and allows them to grow consistently.
Coke provides an excellent example of how a moat can bring long-term success.
“Quite frankly, there is nothing particularly magical about Coke,” said Pabrai. “[It is] really easy to clone coke, and several companies have done that.”
However, Coke’s brand recognition and reputation have allowed the company to outperform competitors like Pepsi for years, despite offering near-identical products.
Coke’s impressive moat was displayed in the 1980s by an unlikely source – its competitor, Pepsi.
A few years after having entered the arena with Coke, the biggest soft drink brand on the market at the time, Pepsi hosted the now infamous “Pepsi Challenge”.
As part of this challenge, blindfolded participants had to taste a Pepsi and a Coke and declare which they preferred.
The taste test results ruled in Pepsi’s favour – more people preferred their product over Coke. However, when it came to sales outside the challenge, people still went for their traditional choice – Coke.
This apparent paradox inspired researchers to recreate the Pepsi Challenge but, this time, to include a non-blind taste test.
Again, in the blind test, Pepsi reigned supreme. However, when the blindfolds came off, the favour skewed towards Coke.
The results of this test set the stage for Coke’s advertising strategy going forward – lead with the brand, not the product.
Sasfin Securities’ David Shapiro recently made a similar point about the luxury design house Hermes.
“Here’s the Moses test: Do you buy five shares in Hermes or a starting-level Hermes Birkin bag? Both cost R180k. Be careful. It’s a trick question. Because used Birkin bags have an incredible resale value.”
Shapiro found that $100 invested in a Birkin bag ten years ago would be worth around $300 today. However, $100 in Hermes shares would be worth $750.
His conclusion: “Buy the shares. Not the product.”
This also applies to moats – investors should look for companies with a better brand rather than companies with a better product.
More than one moat
However, not all moats look the same, and a company can have several moats working in its favour.
According to Investopedia, a moat is any factor that allows a company to provide a good/service similar to its competitors and still outperform them.
One of the strongest moats companies can have is economies of scale – cost advantages that come when companies increase their output.
Online retailer Amazon is a company that has leveraged economies of scale to its advantage.
Amazon has invested heavily in its logistics and distribution network, which has helped the company to offer a wide range of products at competitive prices.
This investment gave Amazon a cost and size advantage over its competitors, who cannot match its scale or efficiency.
Amazon’s moat has earned it a market cap of over $1 trillion and the title “largest online retailer in the world”.
Another potential moat could come in the form of a regulatory advantage, which usually stems from government actions that limit competitors’ market share.
A local example of this type of moat is telecommunications giant Telkom, which competes with companies like Vodacom and MTN.
Telecommunications is a heavily regulated industry, but through government intervention, Telkom receives preferential treatment from regulators.
For example, Telkom may have access to specific spectrum frequencies or infrastructure, giving the company an advantage in terms of network coverage or quality.
However, this type of moat tends to be the least durable, as Telkom has also illustrated over the years.
Despite its competitive advantage over competitors, Telkom did not make full use of its moat.
Despite its infrastructure, Telkom was slow to adopt new technologies like fibre, and the company lacked innovation.
Therefore, after years of stagnant growth and despite this advantage, Telkom lost out to its competitors.
A word of warning
It is important to note that companies’ moats do not last forever.
Pabrai said this comes down to the “nature of capitalism – a moat will eventually get filled”.
Once a company has established its competitive advantages and reaped the benefits, its competitors will catch on and – sooner or later – duplicate or even improve its strategies.
However, there are ways for companies to strengthen their moats.
For example, one method is to obtain a patent for a particular product or technique. This will keep competitors looking to duplicate the company’s success at bay.
This is why investors need to keep tabs on the strength of companies’ moats – it is important to know whether a company’s advantage is growing or shrinking and to make investment decisions based on that information.
Investor Phil Town has developed a strategy to help investors keep track of a company’s moat.
- Look at the company’s long-term track record of revenue, earnings per share, free cash flow, and equity.
- Check if these factors are consistently growing at over 10% per year.
There are also specific signs that indicate a moat has been filled.
- Declining sales
- Declining margins
- Negative media sentiment
- Closing stores
“The most important thing in evaluating businesses is figuring out how big the moat is around the business,” Warren Buffett said.