What is an economic moat?

Mathew Hodge | 19/10/2015 Text size Decrease

What is an economic moat?

Mathew Hodge: Basically it's something intrinsic to the business which will allow it to earn excess returns. So returns on invested capital above its cost of capital for an extended period and for a narrow moat rating we require at least 10 years of excess returns and for a wide moat rating we require at least 20 years of excess returns. The nature of businesses that, if someone's making good money, other people see that, other businesses see that and they want to come in and compete it away. A moat is something that prevents that from being effective or means it takes a long time for that competition to erode returns away.

Which companies have wide economic moats?

There are quite a few in the Australian market, the banks have wide economic moats, they are pretty good franchises here and they have quite a significant cost advantage relative to the second tier banks. In the smaller companies we've got Veda, which is data gathering, its actually undertaken a bit at the moment. It's in the credit - personal credit rating business which we think has got potential.

What is the difference between a wide and narrow economic moat?

It's all about the duration. How long is it going to take for those excess returns to be eroded and you might have say a pipeline for example that’s only going to earn a few percent returns above its cost of capital, but if you can do that for a long period of time. If we can see that it's going to do that for 20 years that's wide moat. Narrow moats are still better than average, most companies do not have – most businesses do not have moats. But a narrow moat means that we don’t have the confidence to say, there is a better than average chance in 20 years that the business will still be earning excess returns.

Something like Dulux is one that we've got in the narrow moat bucket and that’s because they are extremely strong and their brand is strong. But Bunnings is becoming quite a strong force and if you think 20 years in the future. What might be the bargaining power between Bunnings and Dulux. Is it going to evolve to situation like Coca-Cola in the supermarkets, that’s something that maybe could happen on a 20 year time frame. But I don’t think that’s going to happen on a 10 year timeframe, so we've got Dulux in the narrow moat bucket.

5 sources of economic moat

So the first one is intangibles and that’s brands, patents, licenses things like that. So healthcare tends to fill in that bucket. So it's Cochlear companies like that. Switching costs, is it difficult to move from one provider to another and things like MYOB, accounting software they fit into that kind of bracket. In the US they have even better examples like Oracle which once you put that into your business, it's extremely painful to get in and then painful to get out. Microsoft is also a pretty good example, the switching cost doesn't necessarily have to be just pure money either, it can be time, if it's a pain in the backside to get rid of it, then people won't chose something else. So Excel, Word, people are used to using those. There would be a high cost in terms of efficiency of using something else, so people don't bother doing that.

Network effect, the classics like eBay or Facebook, MasterCard, Visa, that’s where the more people that join the network, the stronger the network becomes and the more value that individual users get. An example I like is MasterCard, the more people who have MasterCard credit card, the more businesses will accept payment and the more businesses accept payment via credit card, the more incentive for people to have MasterCard, it just becomes more useful.

In Australia we got – in New Zealand we've got Trade Me, but also the internet type businesses like SEEK and Carsales fit into that bracket as well. Cost advantage that tends to be where the only source of moat for resource companies, but it's also a source of moat for say Wesfarmers, or Woolworth a low cost provider of groceries. But if there is going to be moat in resources, it's going to be from cost advantage.

Efficient scale is the last one and in simplest terms is, doesn't make sense for this market to be served by just one or two or three players. So good example airports, so Perth airport there is one built, there is very little incentive for another one to be built. If someone came in and built a new airport it would destroy returns for both assets. So airports tend to be efficient scale moats. Pipelines, railways things like that, where it makes sense to just have a few players. They tend to be efficient scale businesses.