Recently, I interviewed Todd Wenning on the competitive advantage. Todd Wenning, CFA is an equity analyst at Johnson Investment Counsel. Before joining Johnson in 2015, Todd was an equity analyst at Morningstar and ran a dividend-focused newsletter for The Motley Fool UK. He is the author of Keeping Your Dividend Edge (2016) and his articles have been published by Morningstar, Investors Chronicle, CFA Institute, and The Motley Fool. He also has blog Clear Eyes Investing. Todd's opinions here are his own and not necessarily those of his employer.
What does competitive advantage mean to you? How do you describe a moat (in general)?
There are two types of competitive advantages - temporary and durable. A company that sells a "fad" product, for example, might generate high profit margins and returns for a time, but eventually, competition enters, and the trend ends. Fidgit spinners are a case in point. Instead, what I'm looking for as an investor are durable advantages, or "economic moats." Whereas new competitors quickly eliminate a temporary advantage, a durable advantage is something that keeps competitors from eating away at your profits for an extended period. Ideally, a moat will enable a company to generate high returns on invested capital for more than ten years. There are four main moat sources, in my opinion - intangible assets (patents, brands, regulatory protection, etc.), switching costs, network effects, and low-cost production.
Looking at Morningstar’s five main types of moats, which is most crucial for a company to have?
The importance will vary by company. For example, a commodity producer doesn't need to have a brand advantage or network effects on its side. What it wants to have, however, are low-cost production advantages. Companies with particularly wide moats typically have more than one moat source. Apple's moat, for instance, is anchored by a valuable brand (you're willing to pay up for an Apple product) and switching costs (once you're in the Apple ecosystem, it's costly in time and money to change to Android or another ecosystem). It's hard enough for a company to dig one moat, let alone two or more, so these are exceptional companies that fit this mold.
What is a good example of a moat that consumers directly experience?
As consumers, we most frequently experience intangible asset brand advantages, though this is changing in some ways due to technology. As we spend more of our lives consuming digital content, for example, we'll likely encounter more software-related moat sources like switching costs and network effects. One mistake investors make is equating a brand's market share or awareness alone as a moat source. To be a moat source, a branded product must command a higher price relative to comparable products. It also can't be explained by higher production costs alone. Even though you're well aware of GM and Ford automobiles, for instance, you're not likely willing to spend more money for the privilege of driving either one. On the other hand, luxury car manufacturers like Ferrari, BMW, and Mercedes can mark up their products because they don't just sell cars - they also sell experiences.
Why is it important for investors to know about competitive advantage? Does it give investors any advantage to know about competitive advantage?
The market often assumes - and usually correctly - that companies will experience a reversion to the mean on their returns on invested capital due to competition. No company's moat lasts forever, of course, but moats enable firms to generate higher returns on invested capital for much longer than the market likely suspects. If your assumptions about a firm's return on invested capital persisting for longer than what the market's priced in turn out to be correct, you will end up making money.
What’s your favorite moat and why?
My favorite moat source is intangible assets, specifically brand. I find the psychological effects of brands to be fascinating. When I take a sip of Coke, for example, I always remember drinking Coke out of glass bottles at my late grandmother's house. There's a deep link between taste, smell, brands and memories. Buffett has noted that this is one reason why Coca-Cola wants to be everywhere fun times are happening - sporting events, concerts, amusement parks, and so on. They want to make that connection between the brand and your memories.
Thinking about moats in different types of companies: in growing companies, they want to continue to increase their margins and customer base; and for defensive companies, it may be more about stability and safety. What kinds of moats are most successful in companies that look to grow versus those that try to defend their competitive position?
Interesting question. I think it varies by the type of business. If you're a growing software company, for instance, you want to establish switching costs or network effects as quickly as possible. This is why software companies tend to offer free trials to products. They want to make the software part of your daily routine so that it will be harder to stop using it when the trial ends. If you're an established consumer products company with a brand advantage, you should focus on defending that brand at all costs by investing in marketing, advertising, and innovation around it.
Thank you to Todd Wenning for his insights on competitive advantage. I had a few takeaways from his very thoughtful responses. The power of more than one moat source leads to a longer lasting competitive advantage for the company. Meaning, that while finding companies like that are extremely rare, once you do you can rely on them for the long haul.
In Todd’s example on Ferrari and BMW. They are selling more than just the physical product and are successful with making an experience for their customers, which leads to a great brand. And a great brand can be a very powerful (if not most powerful) moat. As Todd said Coca-Cola is a great example, but you can find these brands everywhere. One that sticks out to me is Mattel, whenever that brand comes up I always think about happy little girls playing with Barbies.
Lastly, I underestimated the switching cost moat. It can be used to hold onto customers and is especially helpful to up and coming businesses. Along with technology companies like Apple, Android, etc., these switching costs apply to other companies like Verizon, AT&T, T-Mobile, etc..