What Is The Best Type of Moat?

And why it matters

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This week, we welcomed John Rotonti of the JRo Show to the Investing Power Hour live podcast.

John loves studying the philosophy around fundamental investing, so I tweeted a question on moats:

A lot of responses said branding was a weak moat. Others said that economies of scale and/or capital intensity were weak moats.

Most preferred network effects, regulatory capture, and high switching costs (which can all be intertwined, for example Visa/Mastercard).

I agree that branding is a weak moat, on average. Perhaps a better way to think about it is that brands can be strong for a short while and deliver huge outsized profits. But, it is hard to have confidence in brand durability except on rare occasions (Ferrari, Coca-Cola, etc.).

I think brand moats work well when combined with other competitive advantages. American Express earns outsized profits because it is a strong brand and has a network effect. Apple earns outsized profits because it has a strong brand and high switching costs (and blue bubbles, sigh).

Unlike a lot of these responders, I like economies of scale and capital intensity as moat drivers. I think it is much more predictable than a brand-driven moat, giving me confidence in durability. This comes back to the Nick Sleep idea of scaled economies shared (Costco, Amazon) where the low margin and increasing customer value proposition at scale continually separates the company from the competition.

Of course, capital intensity requires, well, a lot of capital. Profits have to be reinvested to maintain and grow the moat, which is money that cannot be redistributed back to shareholders.

This is why asset-light businesses with high switching costs, regulatory capture, and/or network effects are the undisputed superior business models.

Some of the widest moat stocks in this category have delivered phenomenal long-term returns.

FICO has compounded at a 24% clip since 1990

Visa has compounded at a 21% clip since going public in 2008:

Microsoft has compounded at a 22.7% clip since 1990:

(although it is now more capital-intensive)

Moody’s has compounded at a 16% clip even with the GFC scandal:

Adobe has compounded at a 19% clip:

I could go on. These are capital-light businesses with major competitive advantages that allow them to generate growing free cash flow over decades. If paired with a decent capital allocator that only needs to say “Hey shareholders, take this cash” you get market-beating returns.

Gross profit royalties, as Buffett calls them.

One might argue a company such as Costco has a wider moat due to its huge economies of scale and cost advantage. I can buy that argument.

But is it a “better” moat? Costco’s stock has compounded at 17% since it went public and is perhaps the best example of economies of scale leading to strong long-term stock performance. It has also had quite the multiple expansion.

It just simply can’t be better than another wide moat stock that is not capital intensive. Because the capital intensity eats up the cash that is supposed to be returned to you as a shareholder:

Source: Buyback Capital.

Therefore, the best businesses are those that:

• Have wide moats from network effects and switching costs

• Are not capital intensive

• Can grow without new capital

• Have a rational capital allocator at the helm

Is that so much to ask?

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