Why we like economic moats

Charlie Huggins (CFA) - Fund Manager

12 January 2017

In a competitive world, success always attracts attention, and businesses generating strong competition can expect rivals to appear on the scene before too long. But a few businesses manage to fend off the impact of competition, because, in the words of Warren Buffett, they possess an 'economic moat' that defends them, resulting in sustainable pricing power and margins.

Economic moats can come in the shape of patents, brands, or other advantages, the important thing is that each moat, in its own way, must be tough for rivals to breach. In our opinion, every company within the HL Select UK Shares fund has some sort of moat, and here are a few examples.

1. Intangible assets

Most, if not all, of our holdings have some form of intangible asset; such as a strong distribution network, or a collection of unique brands. The consumer goods companies, Unilever, Reckitt Benckiser and Diageo – owners of brands like Dove soap, Dettol and Guinness – are fine examples. As is Burberry, the luxury goods maker.

Consumers trust these brands to meet their needs or aspirations and have formed a strong emotional attachment. Just look at how much people will pay for a Burberry trench coat, let alone a bottle of Johnnie Walker Blue Label . This brand loyalty is often very hard for other companies to compete with, potentially enabling high returns on capital to be sustained for many decades.

2. High switching costs

Sometimes a company's product is so well integrated into a customer's trading infrastructure and workflow that switching to a competitor's product would simply be too costly and risky, creating a broad and deep moat.

Sage and Fidessa provide software that is integral to the day to day operations of their customers. Even if a competitor offered the same product 20% cheaper we feel it is very unlikely a customer would go to an alternate provider because the cost and upheaval of doing so just wouldn't be worth the effort; for example, staff would have to be re-trained in use of the software.

This means customer renewal rates are very high, and their revenues are mostly recurring, resulting in very strong cash generation. Both reinvest these strong cash flows into new product development in order to win new customers, and increase the value of existing relationships, which should help to deepen their economic moats over time.

3. Network effects

A network effect means providing a service that increases in value as the number of users expands. Auto Trader, Just Eat and Rightmove are excellent examples. Each provides a platform that links a fragmented group of buyers and sellers together in one place. The more customers that list cars, homes or restaurants on the platform, the more likely buyers are to go to that site. This attracts even more sellers, resulting in a virtuous cycle.

These three businesses dominate their respective industries, providing an enormously powerful network effect and economic moat. This is evident in the pricing power exerted by each business. Both Auto Trader and Rightmove managed to increase their average revenue per customer by 10% in the last financial year. Just Eat recently raised the amount it charges UK takeaway owners to list on its platform, with virtually no impact on demand. The average operating profit margin earned last year by these three businesses was 49% and analysts predict each will go on to grow those margins further, both this year and next, although there are no guarantees.

4. Cost advantage

A cost advantage that comes from scale - spreading fixed costs over a large base - is often very difficult to copy. So we like dominant players in fragmented industries.

WPP, the world's largest media and advertising company, is a good example; as is Bunzl, the distribution specialist which dominates a very fragmented market place. The sheer scale of both businesses gives them excellent buying power and allows them to significantly out-spend competitors, in order to stay ahead. It would take another company many, many years to achieve the scale each business has today, which is a considerable barrier to competition.

Conclusion

Time is the friend of the wonderful business with an economic moat. A moat allows businesses to compound their cash flows, at high rates of return, over long periods of time, creating enormous value for shareholders.

This is why we prefer to pay up for those businesses we consider exceptional and which we feel have sustainable competitive advantages, rather than purchase 'cheaper', but inferior businesses that struggle to maintain high returns on capital. It's also why we invest for the long term, in order to try and capitalise on the compounding power of moated companies. Although there are no guarantees, and we won't get it right every time.

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Please note Charlie Huggins personally holds shares in Reckitt Benckiser.