What constitutes a suitable Moat?

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kcowan
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What constitutes a suitable Moat?

Post by kcowan »

A recent discussion over in Clippings made me think this would be a worthy topic on its own:
kcowan wrote: 21 May 2017 10:42
ghariton wrote: 21 May 2017 10:08At the extreme, that would be the lottery ticket approach to investing. Apparently, it is quite popular with some people.
George
Ironically, all the super-rich made their fortunes through stock concentration! JD Rockafeller with Standard Oil, Gates, Musk, Ellison, any founder of a successful company, even Buffett!

So the challenge is to Invest in those companies right after they go public and hang on long enough! Both Nortel and BBY gave plenty of signs when the good times were over! Yes it is risky but not rocket science. But it requires you to be hands on.
ghariton wrote: 21 May 2017 11:36
Shakespeare wrote: 21 May 2017 11:18
Ironically, all the super-rich made their fortunes through stock concentration!
You concentrate to make money (if you can stand the risk) and diversify to keep it.
To Keith Cowan's point, most of the super-rich did not make their money by taking risky investments. They made their money by exploiting monopolies that produced something that was popular or, even better, a necessity. A low-risk avenue...
George
SkaSka wrote: 21 May 2017 14:55
Lazy Ninja wrote: 21 May 2017 11:51
SkaSka wrote: 21 May 2017 01:26 The competitive pressures of capitalism are simply too much for the vast, vast majority of companies to be able to generate excess returns on capital above the cost of capital for very long.
Thus the importance of moats.
Yes moats are incredibly important in order to maintain returns on capital above the cost of capital for prolonged periods of time, which creates excess returns. However, with the frequency in which the word "moat" is bandied about in the world of finance, one might mistakenly be under the impression that moats are easy to create and defend: they are not as it is incredibly rare to build strong moats that can withstand the forces of capitalism and time!
I picked these posts up from the Clippings thread because I think that it raises a key point in the selection of individual stocks.

So what are these moats that we should be looking for? I am a technology guy so I will start there:
IBM
There were seven contenders to dominate the computer business in the 60s. IBM bet on a single architecture and won.
Digital
They were uncontested for grabbing the minicomputer space. Data General was a strong second.
Tandem
They owned the non-stop computing segment.
PCs
Initially a messy group, with Apple having an early lead. IBM offered an open system with help from Microsoft.
OS
Microsoft dominated from day one by offering their OS for $8 on any computer that wanted to ship it. Gates brilliance in that strategy earned him billions.
Handhelds
Many contenders until Apple introduced the iTunes and App store. Android has the most placements but the least profit.
Wearables
No leader has emerged. Google is a leading contender.
Search
Google remains the leader.
GPS
Garmin remains the undisputed leader.

I have probably missed some categories but that will do for now. I know many will disagree or quibble with these choices. But the point is to establish a pattern that can be used for the future.
Let me talk about some specific stocks that don't fit into any of these categories:
Oracle - a database company using IBM patented technology
Cisco - the backbone of the internet for 10 years
Palm - the leader in palmtop computing
Blackberry - the leader in handheld pagers
Nortel - the global telecom competitor
Jones Soda - a non-standard soda distribution company
Lululemon - a non-traditional wearables company
American Movil - a cellular company in Latin America
All of these had their day making 20x their initial stock price. All of their moats eventually eroded.

So what are there now?
Amazon
Facebook
Google (still)
New Flyer Industries

So what were/are the definable moats for these companies, if any? How sustainable are they?
Are there any others that have proven themselves to be suitable picks right now and why?

Wise words from Sensei:
Sensei wrote:anyone else looking for reliability need to focus on moats. The average life expectancy of a company on the S&P is less than 20 years. Thus when we are looking for stability in a company, we need to ask ourselves why that company will be around in 20 years and if we can't answer that question, cross it off the watchlist.
Here are the top ten in the US over ten years:
TopTen.jpg
Home Depot (HD) closed at all-time highs today. $5000 invested in Home Depot when it went public in 1981 is worth about $30 million today. Turning 5k into 30 million for 35 years means that HD compounded at an average annual rate of 28%. 28% annual appreciation for 35 years is very, very rare.

To compare to some of the best-performing stocks of all time: 5k invested in Microsoft in 1986 is worth about $4.85 million today. 5k invested in Walmart in 1975 is worth about 29 million today. 5k invested in Applied Materials (AMAT) in 1975 is worth about 22 million today.

Finding a stock that has the potential to compound at 28% annually for 35 years is close to impossible and probably, it won’t be repeated ever again. Holding such a stock for 35 years might be even harder.
What say you?
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Re: What constitutes a suitable Moat?

Post by Shakespeare »

Many moats are unpredictable - a new product that catches on with something that makes it difficult to easily replicate.

It's easier to identify established companies that own infrastructure that can't be replicated today - the railroads, for example. But a current moat can be bypassed: emerging countries went straight to wireless, bypassing copper.

Myself, I prefer to lock in gains by selling on the way up; this is what I did with my high-tech fund (Trimark Discovery). When it collapsed I had already made and kept a decent profit.
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Re: What constitutes a suitable Moat?

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kcowan wrote: 22 May 2017 15:25 Let me talk about some specific stocks that don't fit into any of these categories:
Oracle - a database company using IBM patented technology
I've been more than familiar with Oracle for over two decades and it's the first time hearing such a thing.
IBM makes the DB2 database software, competing with the main Oracle product.
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Re: What constitutes a suitable Moat?

Post by Lazy Ninja »

Those are some crazy numbers on Home Depot. It seems particularly hard to find wide-moat companies in Canada. I remember a couple of articles in the Globe and Mail where Morningstar identified all the publicly traded companies that they judged to have wide moats. The first version had nine companies and included all five of the big banks. A more recent version identified only eight which I believe were Royal Bank, TD, Bank of Nova Scotia, Enbridge, Potash, Ritchie Bros. and the two rails.

This is from "The Five Rules of Successful Stock Investing" by Pat Dorsey:
In general, there are five ways that an individual firm can build a sustainable competitive advantage:

1. Creating real product differentiation through superior technology or features
2. Creating perceived product differentiation through a trusted brand or reputation
3. Driving costs down and offering a similar product or service at a lower price
4. Locking in customers by creating high switching costs
5. Locking out competitors by creating high barriers to entry or high barriers to success
He gives a couple of examples for each category(some of which may be a little dated. The book was published in 2004), with the exception of the first.

Category 2: Tiffany, Coke, Disney
Category 3: Southwest Airlines, Dell, UPS
Category 4: Stryker, Zimmer
Category 5: Microsoft, Pfizer (via patents), eBay, Western Union

Here are his concluding remarks regarding the first category:
The lesson here is that although firms can occasionally generate enormous excess profits - and enormous stock returns - by staying one step ahead of the technological curve, these profits are usually short-lived. Unless you are familiar enough with the inner workings of an industry to know when a firm's products are being supplanted by better ones, be wary of firms that rely solely on innovation to sustain their competitive advantage.
In my own portfolio, I consider CNR, Union Pacific, Visa and MasterCard to have the strongest moats. I don't know if I would go so far as to say that they're unassailable, but they are certainly well positioned. Starbucks and Nike are two others that I own that would fit category 2. Visa, MasterCard and Ritchie Bros. are examples of the network effect, which I believe Morningstar considers to be the strongest type of moat.
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Re: What constitutes a suitable Moat?

Post by Thegipper »

I can think of retailers who could have checked every box 15 year ago and along comes on line shopping and Amazon. I recall a company called Blackberry who thought they had a wide moat. Technology is bringing down a few strong moats. Canadian banks have invested heavily in tech to avoid an assault from fintechs. I am not as confident about moats as I once was.
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Re: What constitutes a suitable Moat?

Post by SQRT »

The big CDN banks have demonstrated an ability to maintain their "moats" over long periods. Beating the Index by 3-4% per year for about 50 years is impressive. Maybe not as "explosive" as some other examples but probably was less risky?

In tech, the envireonment is very dynamic and more difficult to predict. As banking has become so dependant on technology, one could certainly make the case that it will be more difficult to maintain their "moats" in the future.
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Re: What constitutes a suitable Moat?

Post by kcowan »

adrian2 wrote: 22 May 2017 17:35
kcowan wrote: 22 May 2017 15:25 Let me talk about some specific stocks that don't fit into any of these categories:
Oracle - a database company using IBM patented technology
I've been more than familiar with Oracle for over two decades and it's the first time hearing such a thing.
IBM makes the DB2 database software, competing with the main Oracle product.
IBM patented the DB2 technology in 1968 but, at the time, IMS was the only database product for them. By the time they realized how powerful relational technology was, Oracle already had an insurmountable lead. They enjoyed the early adopter moat. Oracle also illustrates the value of focus in the early years.
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Re: What constitutes a suitable Moat?

Post by adrian2 »

kcowan wrote: 23 May 2017 10:06
adrian2 wrote: 22 May 2017 17:35
kcowan wrote: 22 May 2017 15:25 Let me talk about some specific stocks that don't fit into any of these categories:
Oracle - a database company using IBM patented technology
I've been more than familiar with Oracle for over two decades and it's the first time hearing such a thing.
IBM makes the DB2 database software, competing with the main Oracle product.
IBM patented the DB2 technology in 1968 but, at the time, IMS was the only database product for them. By the time they realized how powerful relational technology was, Oracle already had an insurmountable lead. They enjoyed the early adopter moat. Oracle also illustrates the value of focus in the early years.
My point is that Oracle is not using IBM patented technology.
Both DB2 and Oracle are examples of relational databases, among many others.
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Re: What constitutes a suitable Moat?

Post by kcowan »

adrian2 wrote: 23 May 2017 13:45My point is that Oracle is not using IBM patented technology. Both DB2 and Oracle are examples of relational databases, among many others.
OK sorry. My bad. That was more illustrative and not an attempt to smear Oracle who built a successful business on relational databases. In a way, it was to show the number of opportunities that IBM passed up through lack of focus. It took them 15 years after they had their patents to even pursue the commercial opportunity (proven by Oracle).
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Re: What constitutes a suitable Moat?

Post by Hammerer »

Thegipper wrote: 22 May 2017 19:27 I recall a company called Blackberry who thought they had a wide moat. Technology is bringing down a few strong moats.
BBRY had such a huge moat, but didn't realize it was in network effects, not hardware.

If they had opened BBM to other devices, they could have been Whatsapp, which Facebook bought for 3x BBRY's *current* market value.
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Re: What constitutes a suitable Moat?

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Bumping in response to Moneyscribe's question on why I bought rails recently.
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Re: What constitutes a suitable Moat?

Post by albertablue »

Being a career pipeline guy I suggest as long as we need hydrocarbons the big pipes have a huge moat. When we will see peak oil is debatable certainly

Cost to build has skyrocketed limiting new pipes and giving environmentalists a very effective avenue to get at and limit incremental development. The moat is I think akin to the railroads. They certainly need complimentary businesses (like bruce power for TRP) to keep their current model going

That also makes those with extensive network of existing depreciated pipe highly valuable and able to acquire existing pipe and enhance the network

All highly debatable if you see the oil industry as heading for a buggy whip scenario in the short term
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Re: What constitutes a suitable Moat?

Post by Eclectic12 »

adrian2 wrote: 22 May 2017 17:35
kcowan wrote: 22 May 2017 15:25 Let me talk about some specific stocks that don't fit into any of these categories:
Oracle - a database company using IBM patented technology
I've been more than familiar with Oracle for over two decades and it's the first time hearing such a thing.
IBM makes the DB2 database software, competing with the main Oracle product.
The closest I am aware of is Ellison read about the IBM System R database in an article from an IBM Research Journal. He thought it would be good for Oracle (then named Software Development Laboratories) to have a compatible product. This failed though as IBM kept the RDBMS error codes a secret.


For IBM itself, my understanding is their competitors required ditching any already owned equipment. IBM, on the other hand, let the customer hookup the equipment they already owned, reducing costs. Reduced costs seemed to be their initial moat AFAICT. Later on, IBM's prestige became a moat.

I can remember being told how buying IBM equipment was never a bad move. There was also the insurance company executive (prior to my time) who was tasked with buying the most cost effective and best technically equipment. Digital beat IBM, the equipment was installed/used for years and the executive was fired for not buying IBM equipment. :shock:


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Re: What constitutes a suitable Moat?

Post by kcowan »

I would guess the IBM moat lasted for 20 years and then extensions to legacy systems kept them going longer.
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Re: What constitutes a suitable Moat?

Post by Eclectic12 »

Are we counting people as moats as well?

Recalling what I read of IBM history, Watson Sr. though computers were too risky and had a too limited potential market to invest in them. Had Watson Jr. gone along with Sr. and the board - IBM staying put with their punch card tabulating systems might have meant being swept away, relatively quickly.

IBM was behind the ball as they produced their first in 1953 where the US census bureau started using the Univac in 1951.
A British food and catering company also started running their business in Nov 1951 then branched out to build computers as well as provide services to British industry.

IIRC, one of IBM's main competitors had a CEO who like Watson Jr., saw the potential but had to ride herd on the board thought along the same lines as Watson Sr. The CEO's death in a private plane accident was the all board needed to kill the computer business - despite it doing well in competition with the rest of the market.


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Re: What constitutes a suitable Moat?

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Eclectic12 wrote: 02 May 2023 09:35I can remember being told how buying IBM equipment was never a bad move. There was also the insurance company executive (prior to my time) who was tasked with buying the most cost effective and best technically equipment. Digital beat IBM, the equipment was installed/used for years and the executive was fired for not buying IBM equipment. :shock:
"No manager ever got fired for buying IBM" used to be a mantra in the business world.

Your insurance company executive was "courageous" in the Sir Humphrey Appleby sense of the word.

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Re: What constitutes a suitable Moat?

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kcowan wrote: 02 May 2023 10:36 I would guess the IBM moat lasted for 20 years and then extensions to legacy systems kept them going longer.
My recollection is more like 30 years, starting in the mid '60s with S/360 and running to the mid '90s with the transition to mini and micro computers when IBM had a "near death experience.)

Many people forget that IBM literally bet the company on S/360. It was a $5B bet (~$50B today.)
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Re: What constitutes a suitable Moat?

Post by Eclectic12 »

If you are starting with the S/360 to get about thirty years, I would argue you need to add at least another fifteen years or so.
Despite introducing the IBM 701 after the Univac was up and running, by 1956, IBM had 85% of the market.

It might be even longer considering IBM's innovation of using a narrow, rectangular hole on punch cards meant the circular hole 45 column punch cards became obsolete when IBM's had 80 column. Like Gates tying copies of his OS to computers built, both Remington Rand and IBM tied sales of punch cards to sales of their hardware. The US gov't sued in 1932 with IBM arguing the cards part of the machine that were leased. The US Supreme Court ruled IBM could only set the specifications. Despite the setback, in 1937 IBM had in one location in the US, 32 printing presses churning out between 5 to 10 million punch cards a day (including printing, cutting, stacking and packaging).


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The first "bet the company" was during the depression. The company kept churning out equipment at full capacity for six years with no market to sell to and ballooning inventory in storage. During this time, for employees - group life insurance, survivor benefits, paid vacations and a school house to educate/train were added.

The bet paid off when the 1935 Social Security Act aka "the biggest accounting operation of all time" came up for bidding. IBM was the only company with a large enough inventory.
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Re: What constitutes a suitable Moat?

Post by kcowan »

Yes I guess with the added perspective, IBM was dominant from 35 to 95, 60 years! An amazing moat indeed.

Their emphasis on hardware gave room for Microsoft and Linux to emerge and thrive. But the market was large enough.
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Re: What constitutes a suitable Moat?

Post by ghariton »

You guys are way older than me.

My first experience with IBM products was in graduate school in the 1960s. That was when they introduced the first System 360/20, I believe. It caused quite a bit of consternation among my fellow students (and my graduate advisor). Write a simple two-line program. Read X, and then write X. Feed it 1.00000 and get back 0.999996.

Some of us were very interested in cumulative rounding error back then. John Tukey and his gang petitioned the university to yank out the S 360 and go back to the 1620 (I believe). Nothing came of it. The reputational moat was wide indeed.

(For those who don't think rounding is a big deal, take the matrix whose (i,j)th element is 1/(i+j-1) and invert it. Then multiply your inverse by the original matrix and compare to I. Choose a reasonable-size matrix, say 20x20.

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Re: What constitutes a suitable Moat?

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kcowan wrote: 03 May 2023 12:22 Their emphasis on hardware gave room for Microsoft and Linux to emerge and thrive. But the market was large enough.
There were some notable missteps. Designing the IBM PC with an open architecture was a smart move. But then when third parties offered compatibles at substantially lower prices, IBM's response was to transition back to the "old ways" of the closed architecture in PS/2. That turned out to be a dumb move. And on the software side Bill out-negiotiated the other Bill [Lowe] in the licensing of PC-DOS.

As for Linux and also open systems in general, IBM was slow to respond because of their reliance on proprietary standards in areas like operating systems and networking.

Of course that's now obvious only in hindsight.
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Re: What constitutes a suitable Moat?

Post by Bylo Selhi »

ghariton wrote: 03 May 2023 12:42 You guys are way older than me.

My first experience with IBM products was in graduate school in the 1960s.
Older? I started my adventures in computing while in high school in the late '60s.
Some of us were very interested in cumulative rounding error back then. John Tukey and his gang petitioned the university to yank out the S 360 and go back to the 1620 (I believe). Nothing came of it. The reputational moat was wide indeed.
It wasn't all bad. Countless academics made full professors with tenure from writing papers on rounding errors and how to mitgate them on digital computers.

As for IBM's moat I recall that gummy wrote a book (page 50+) that documented the experience of UW's Math faculty in ditching the IBM S/360-75 in favour of the Honeybun.
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Re: What constitutes a suitable Moat?

Post by AltaRed »

C'mon folks. This is not an IBM thread.
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