Moats aren't forever

Most investors seem attracted to growing companies with large competitive advantages (a moat).  Who wouldn't want to own Apple as it went on to dominate the world.  Companies with moats are the types of stocks people talk about at parties when they say things like "I purchased Proctor and Gamble in 1988 and it paid for my retirement."

Growth investing will always be popular with a large segment of the market.  I know many co-workers have invested in "growth" funds because they want their money to grow, a fund with value in the name just sounds cheap, like a value meal at a fast food joint.  It doesn't help the image that many value investors are actually cheap themselves, some even fall beyond the cheap realm into the miser category.  Investors have a choice between a growth fund run by a slick looking guy wearing fancy clothes and driving a nice car and some value fund manager who's sport coat has elbow pads and drives a gremlin.  

Many readers know that I don't seek out companies with moats or competitive advantages as the market sees them, but I pick through the market's dustbin.  I don't think I've ever articulated why I don't seek out moat-ish companies, so I want to use this post to lay out my thoughts.

This idea came to me recently as I was reading an article about the recent Carnival Cruise Lines incident.  For readers who were unaware a Carnival ship had a fire which left it disabled in the water for a week.  Passengers were trapped without food, water or toilets.  The biggest story seems to be that passengers had to sleep on the decks and that raw sewage was running through the halls.  As I was reading the article I started to think about a series of posts Geoff Gannon and Quan Hoang wrote here about Carnival and the company's moat.

I wondered how badly Carnival's reputation would be harmed from the incident, some customers might shrug it off and say it wasn't the cruise line's fault, but for many others the name would be connected with a terrible experience.  No matter how many free vouchers Carnival gives to customers the brand damage has been done.

I thought about this in a broader context, the difference between investing in a cheap stock, and investing in a company with a moat.  A company with a moat needs to always be innovating and leading the pack to ensure their moat is safe.  One or two missteps could destroy their advantage entirely.  Maybe Carnival's advantage is their economy of scale, but scale doesn't matter if customers don't book cruises.  A company with a moat cannot sit back and rest on their success, the second they do they lose the lead.  Value investors are familiar with a number of companies that lost their moat such as Blackberry, Radio Shack, Best Buy and others.

On the other hand a cheap deep value stock is just the opposite.  The market has priced these stocks as if they are worse then dead.  I sometimes think of deep value investing like this, it's as if everyone predicts a city will be utterly destroyed by a nuclear bomb but instead most of the city just catches on fire.  When expecting a nuclear bomb a city-wide fire is a relief, complete destruction didn't happen.  Deep value investors need to be ready for bad news, it will happen, it will happen often and frequently.  But sometimes the bad news isn't as bad as the market expects causing the stock to rise.  The corporate corpse is found to have a faint pulse and investors rejoice, certain death was avoided and the company is repriced.

There's a completely different mindset required for investing in value companies verses moat companies.  To invest in a value situation all one needs to be sure of is that death isn't certain.  If a company isn't terminal, and has value then it could be worth an investment.  There is no glamour in buying these stocks.  No one recognizes the names in my portfolio, but that doesn't bother me, returns don't come from popularity.

I'm convinced buying companies with a competitive advantage and concentrating a portfolio is the path to riches.  There isn't anyone on the Forbes 500 list who constantly churned a portfolio of net-nets, they all founded companies with competitive advantages and put their entire net worth, and often their entire life into the company, the epitome of concentrating an investment.  If one wants to be rich I think they need to be an entrepreneur, they need to find an unserved niche and serve it and pour everything they have into that company.

If one can't start a company themselves the second best thing they could do is to invest in a company that has those characteristics.  Many more people made money investing in Starbucks or Microsoft when they were startups than investing in mature companies with leading competitive positions.  Buying into a small company with a defensible niche is probably the second quickest path to riches.

The problem is most investors really don't know what they're looking for when they're looking for a moat.  I was on a flight recently and started talking to my seat-mate.  Maybe this sounds weird, but I can't help myself from talking to people.  If I'm standing next to you for more than a minute we'll be in a conversation.  It turns out he owns a large trucking company familiar to almost any American who has ever driven on a US highway.  We talked about the trucking business and some of the challenges he faces along with the Ravens, skiing, and kids.  He made a comment that was interesting when he said "just like all businesses you need to figure out what you can do a little bit different that causes customers to use you."  His business specializes in certain types of loads, and runs their network in a unique way.

What struck me about his comment was that he's correct, and that our view as investors isn't the same as the people who run the businesses we invest in.  In an finance textbook trucking would be considered a commodity business.  One truck is equivalent to any other truck, they can haul loads the same, and it's doubtful anyone would claim a trucking company could have a competitive advantage.  The thing is in the real world every business that's in existence has a competitive advantage, if they didn't they would be gone.  Each company has something that's a little different that causes customers to do business with them.  

Investors without in depth industry experience, or a deep network of contacts can sometimes mistake a normal competitive advantage with a durable lasting one.  They are deluded into thinking a given company has a moat, when in reality every company has some advantage.  An investor who can correctly identify moats at small and growing companies will do well for themselves over the long run.  

To me a deep value investor is like a doctor who can walk into a room and identify quickly that the patient is going to live.  A moat investor is a doctor who can walk into a room and tell that the patient is the next Frank Sinatra.

Talk to Nate