Moat and The First Principle
Einstein did it, Descartes did it, Steve Jobs did it, Elon Musk did it… and many other pillars of our civilization did it. They call it “The first principle”.
In Mathematics, the first principle indicates the starting point of reasoning. It refers to going back to the most basic of fundamentals and starting to think from there. Thinking by one’s self, as if no one else had thought about the issue before. That is how Elon Musk was able to replace NASA’s space shuttle on his own. And how Steve Jobs was able to revolutionize the technology world. And this is how we stopped believing that the Earth is flat.
It is the only way to be truly creative and…. to become a savvy investor.
As in Mathematics, in investment we need to start from the basics. And the most basic endeavor to inquire about is finding the competitive advantage of a company. Or “the Moat” as Warren Buffett likes to call it.
Value investing, as should all investing be, is all about the first principle. First, it requires a margin of safety: an essential feature to limit losses. In fact, very few investing techniques focus on having a margin of safety. For example, technical analysis & proponents of investing by looking at risk/return based on CAPM… do not have such a feature.
Second, it is not a relative investing strategy. The return of a value investor should not be compared to the market. Specially not in the short term. Value investors disregard the market’s view, and some are even contrarians.
In my blog, I like to focus on value investing. For the purity of its philosophy as well as for the discipline it teaches me. I believe it is extremely important to understand it and even more to be able to achieve it.
In this regard, the first principle is critical for value investors; specially for the advocates of Warren Buffett’s philosophy. For Buffett, one of the most important features of a company to buy is to find one with a moat. The moat is essential for the long-term survival of the company and the prosperity of its shareholders. Therefore, as the first principle dictates, forget everything you know about a company and start from scratch. Start by finding the moat.
Some moats are easy to spot. Coca-Cola’s moat for example is its brand name. When I was in Peru, living on an island with a local family on Lake Titicaca, I truly understood the power of branding. On this island, there was no electricity, no kitchen with flowing water and surely no television and advertising. Yet, for the people of the island, having a bottle of Coca-Cola was as important as having a computer. There are many sweet drinks out there. However, due to the power of its brand, a simple water and sugar recipe became as significant as a computer.
Countless have tried to compete with Coca-Cola but all have failed. Not least, the great Richard Branson and his Virgin Cola.
Coca-Cola was founded in 1892, 121 years ago! I can tell you with certainty: although the world is changing at an exponential rate, in 200 years, people will still be drinking Coca-Cola.
Here are some other sources of moat:
– A simple example would come in the form of an exclusive contract that the government grants to a company (electric utilities, cable franchises etc.)
– Access to low costs through patents or superior technologies that its competitors cannot match in the short term. However this moat rarely lasts more than a few years.
– Ability to retain customers because of high switching costs. For example, if a company installs a new software system for all its employees and pays big sums of money to train them to use it, it will be difficult and expensive for it to think about changing its software. Thus, the software company has a moat.
– Barriers to entry due to governmental privileges, licenses, patents copyrights…
– Economies of scale combined with another form of moat. For economies of scale on their own are not worth much. Specially if new competition can arise and steal their market share.
– Extraordinary managers like Steve Jobs. Although this moat will not last for obvious reasons.
Surely, after determining the moat, it is important to confirm it.
There are some ways to do this; we need to look for:
– Constant or growing market share throughout the years
– Pricing power
– High ROIC
– High return on net tangible assets
After having confirmed the moat through the numbers we can focus on price, competition, industry… And only after having a clear idea of where we stand on the company and at what price we would be interested in buying it, can we look at what the market says. This way, we can make sure, it is our view and not the market’s.
Like Descartes said: “We should all doubt everything we can doubt”. Start from the most fundamental aspects and reinvent how things are done. Or at least try to…
This is the only way to be truly creative and to become a savvy investor.