Mikhail Motala, Equity Analyst, PSG Asset Management
A moat is the sustainable competitive advantage that enables a business to consistently deliver excess returns on capital. The protection of these excess returns is imperative to any company’s long-term success. For this reason, we evaluate a company’s moat as one of the components of our investment evaluations, particularly when assessing how much we are prepared to pay for the share.
Valuable businesses generate returns well in excess of their costs of invested capital, which attract new market entrants seeking similar returns. The emergence of competition disrupts the supply/demand dynamic, inevitably drives profits lower and eats away at excess returns. To insulate themselves from diminishing returns, valuable businesses therefore require moats to protect themselves and their profitability, in the form of a sustainable competitive advantage.
Strong moats are a rare find
In our analysis we attempt to assess the economics of the business and the barriers to entry in its industry. It is relatively easy to spot a good business versus a poorly run business. Finding a strong moat, however, is more of a challenge. The problem is that most businesses are susceptible to quite a few different threats. Consider, for example, the way in which technological disruption has reshaped the way in which many industries function – from financial services to hospitality and tourism to local taxi industries across the world.
The second challenge is that not all moats are created equally. A competitive advantage exists either in terms of supply (the way a company produces or delivers its products or services) or demand (how well a company’s products or services suit or serve market behaviour). Supply-based moats dry out over time, whereas demand-based moats often remain intact. Intuitively, it is far more difficult to control the minds of customers than it is to control one’s supply chain. Demand-based moats are thus less commonly found than supply-based moats.
Moats in practice
Despite being generally regarded as weaker than demand-based moats, certain supply-based moats are durable. Capitec is a good example. Capitec was founded in 2001. By contrast, Standard Bank, First National Bank, Nedbank and Barclays Africa (Absa) trace their origins to the 1800s. As a result, Capitec is not burdened with the legacy IT issues and other costs the other banks face. This enables it to operate with a lower cost structure and thereby offer the most affordable banking product in South Africa.
Interestingly, the total cumulative amount that Capitec has spent since its inception on its banking infrastructure (less the depreciation of that infrastructure) is significantly less than our large banks spend annually. To illustrate, the total balance sheet cost (property, equipment and software) of Capitec’s banking infrastructure (720 Capitec branches serving 7.3 million clients) as at 29 February 2016 amounted to R1.4 billion. In comparison, Barclays Africa (Absa) expensed R6 billion on IT costs in the financial year ended 31 December 2015, Standard Bank expensed R5.8 billion, Nedbank expensed R3.5 billion and FirstRand expensed R1.7 billion.
When it comes to demand-based moats, EOH presents a good example. EOH provides its clients with mission critical solutions and services in IT and business process outsourcing. Their offering ranges from implementing and maintaining SAP enterprise systems to ensuring that manufacturing plants operate efficiently. Let’s suppose an EOH client were to switch to a competitor’s cheaper offering tomorrow. The direct costs it would have to incur to train staff and ensure compatibility with existing systems and data, coupled with the indirect costs of slowed productivity, would most likely overshadow any cost saving achieved from switching to the cheaper offering. EOH is integrated into its clients’ business processes and therefore has a formidable hook.
The ideal moat
Businesses with strong moats are often faced with a lack of reinvestment opportunities. As their addressable markets mature, these companies may deploy capital in new ventures outside of their moats. Businesses that are able to reinvest capital and grow their profits within the confines of their moat are incredibly powerful. These businesses are few and far between.