Bookworm: How to avoid falling for a mistaken moat

Welcome to Bookworm, where I share insights from investing and business writing that I find useful. Each insight falls under one of three principles that I think underpin sound individual investing:

Fostering a long-term mindset
Owning high quality assets
Putting process over emotion

Today’s insight is about putting process over emotion. And it comes from an investor that regular readers of this column should be starting to know fairly well.

Today’s insight

If you’re reading this, I assume that you’ve read a few investing books in your lifetime. At least more than the average person. And if that is the case, there’s a good chance that you’ve read (or at least heard of) Peter Lynch’s One Up On Wall Street.

It’s a great read, written by one of the best fund managers of his generation. But like most investment bestsellers, One Up didn’t get there because of those qualities alone. It flew off the shelves because it gave ‘the little guy’ hope.

It did this by making a compelling claim: that everyday people can use their knowledge as a consumer – be it of donuts, coffee or software – to find promising investments before professional investors.

Today’s Bookworm offers a bit of a reality check on that. Or at least something to be aware of if you think you’ve found a Lynchian gem out in the wild.

The danger of mistaken moats

Pat Dorsey’s book The Little Book That Builds Wealth is all about investing in companies with moats.

As you probably know, a moat is a structural advantage or barrier to entry that protects a company and its returns on capital from the most destructive force in capitalism – competition.

All else equal, a company with a moat is more valuable than one without a moat. This is because the moated company has a better chance of 1) investing profitably in its operating businesses for longer and 2) ultimately compounding more in value.

One of my favourite parts of Dorsey’s book is the chapter on Mistaken Moats. These are things that can make you think that a company is of abnormally high quality – that it has a moat – when actually it could be far more ordinary.

Making this mistake leaves you open to the risk of paying a rich price for an investment that you think is of above average quality, but is really just as exposed to the ravages of capitalism as most other companies.

That is not a good combination in the long-term.

A most alluring moat trap

Top of Dorsey’s list of “Mistaken Moats” are… great products. Or in other words, exactly the kind of thing that might pique your interest in a company if you are trying to channel your inner Peter Lynch.

Dorsey wasn’t taking a swipe at Lynch or his book here. In fact, it wasn’t mentioned.

Dorsey was just making the point that unless there is something to stop others from competing with a product successfully, the spurt of higher returns delivered by that product can be short lived.

If you are looking for long-term holdings and compounding, then, you want to find situations where a company’s profits and returns on capital are protected from competition and can endure. As opposed to attracting a lot of competition that the firm has little chance of defending itself against.

An example from the drug world

For an example of the huge difference between having competitive protection and having no protection, look no further than branded drug sales.

When a biotech or pharmaceutical company has a new treatment approved, the molecular formula or biology behind it is generally protected from competition for up to twenty years.

As long as the drug gets the best results for what it treats, the seller enjoys huge pricing power and immense profitability.

When the patent for that product expires, though, other companies will market generic or biosimilar products that copy the science and offer the same results at a fraction of the previous price.

The result? The branded product will often see its profits crater by 80% or more. For many companies, selling a hot product without some sort of protective force can lead to a similar result as we see after a drug’s patent expires. Only much faster.

An example from your local Woolies

Celsius has carved out a niche in low sugar energy drinks. You might have seen their cans in gas stations, in Woolies, or somewhere in the vicinity of your favourite podcaster while they are live streaming.

Celsius’ products have proven rather popular, especially among people who like to see themselves as being health conscious. I have guzzled a fair few cans and can attest that they taste pretty good.

If a Lynch fan saw cans of Celsius everywhere and googled the parent company, they’d be in luck. It’s publicly listed!

What’s more, the company’s sales growth in recent years has been incredible – from around USD 50 million in 2018 to USD 1.35 billion in 2024. That’s a 27 fold increase.

Do winning products alone make a moat in the soft drinks business, though? While our analyst Dan Su commends Celsius’s niche market share gains, she thinks the company is disadvantaged versus the much larger Red Bull and Monster.

The moats enjoyed by these companies don’t come from the products alone. Red Bull and Monster also benefit from:

Globally recognised brands (and loyal customer bases) that have been built through decades of huge advertising spend and product innovation.
Huge distribution thanks to their top-selling status and Monster‘s position as the Coke system’s exclusive energy play. Su says that the latter is more valuable than Celsius’ partnership with Pepsi, where it competes with other brands.
Massive budgets for advertising and product innovation relative to other energy drink players. These can also be fractionalised over much larger revenue base, meaning that they are less of a drag on profit.

“We anticipate Celsius’ larger and better resourced rivals to effectively defend their leads, limiting Celsius’ margin and returns trajectory” Dan’s report says. She isn’t even 100% sure of its ability to fight off innovative smaller players in its niche yet.

Celsius may eventually prove that its brand is powerful enough to defend its position in the energy drink market. But Dan needs more proof that it has enduring brand power in addition to trendy products.

Where does emotion come into this?

We have mostly spoken about moats and business quality so far. But you may remember that I categorised this edition of Bookworm under the “process over emotion” principle.

I did this because finding a great product that also happens to be sold by a public company is exciting. Especially when fewer up and coming companies seem to be public these days.

This excitement can lead to rushed trades and buyer’s remorse. The kind of situation where, a few months later, you look at your portfolio and wonder why you own something – or if it’s really something you’re comfortable holding long-term.

Putting more hurdles between finding new investment ideas and actually hitting the buy button can prevent this. Setting clear investing criteria that align with your investing goal and strategy is a vital step here. As is forcing yourself to actually use them.

For reasons that Dorsey does a great job of laying out in his Little Book, seeking companies with a durable economic moat is one thing that I’d definitely have on this list for long-term investors.

For more on how to set your investing criteria, read this article by my colleague Mark LaMonica.

A closing thought

The purpose of this article wasn’t to dissuade you from following Lynch’s advice and viewing products and services through the eyes of an investor. Far from it.

I’m just saying that in addition to thinking about how good or popular a company’s product might be, you might want to think about how hard it would be to compete with the company selling it.

If you can find a product or service that solves a problem and wouldn’t be easy for competitors to come in and steal customers from, you might really be on to something.