Investing in companies with economic moat
A moat is usually defined as a deep ditch dug around an important area like castle, building etc to provide the area with some preliminary line of defence. In the same light, you could see economic moat as some sort of line of defence around a company with the objective of protecting the business against erosion of its profits and market share. Economic moat is a term popularised by Warren Buffett and it has been largely used to describe companies which have a long term key competitive advantage over the other competitors in the same industry. It was believed that this is one of the most important things he looked into when deciding to invest in a particular company.
So how do you know if a company has any economic moat? And what kinds of economic moat are there?
Well, there are some areas you could look into to determine if a particular company has any economic moat. The most obvious one will usually be customer switching costs. Is it easy for customers to drop the company for its competitors? Or rather how "painful" is it for the customer to be switching products in this case? The more "painful" it is, the higher the customer switching cost and hence the greater the economic moat the company has. Another area will be the network effect. How big is the network effect established by the company so far? Most e-commerce or platforms require a huge network effect to be successful. Take Amazon for an example. The higher the number of shoppers on its platform, the higher the number of retailers on its platform. And this kinda brings forth a reinforcing cycle which further reinforces the economic moat and makes it really difficult for any new players to come in and take market share.
A good example of a company with an economic moat could be Apple. Apple has built such a strong economic moat which provides the business with huge profit margins that is now the first and only publicly traded U.S company to reach $2 trillion in market capitalisation (this is much higher than the GDPs of most countries!). The main element behind its huge economic moat is its OS system which provides a huge incentive for users to use their products or even buy more products. The interconnectivity of the various Apple devices in its OS ecosystem allows you to easily access data from any of your Apple devices or share data among them. If you have an iPhone, you are likely inclined to be getting an Apple Watch as your smartwatch as pairing them is just so seamless. And before you know it, you are also getting an AirPods. Apple has created a scenario where the more of its products you have, the more value you are getting out of its OS ecosystem. This is a perfect case of product stickiness and Apple has done really well to build its huge and deep economic moat.
Now that we have briefly covered what economic moats meant, let's look at how investing in companies with economic moats has been like.
But first, let's define what are the companies with economic moats over the past few years. To do that, I usually refer to the Prophet Relevance Index. The Prophet Relevance Index is an index which measures and ranks the brand relevance of various companies to understand how "strong" the brand is. And in a certain sense, I would relate the economic moat to how "strong" or relevant the brand of the company is. According to the site, it highlights that revenue growth of most relevant brands do outperform the S&P500 average revenue growth by 230% and EBIT growth by 1040% over the course of the past 10 years.
So what are the top 10 brands in terms of brand relevance over the past 4-5 years? Here they are.
2016- Apple, Amazon, Android, Netflix, Google, Samsung, Nike, Pinterest, Pixar, Sephora
2017- Apple, Google, Amazon, Netflix, Pinterest, Android, Spotify, Pixar, Disney, Samsung
2018- Apple, Amazon, Pinterest, Netflix, Android, Google, Samsung, KitchenAid, Spotify, Nike
2019- Apple, Spotify, Android, Bose, Disney, KitchenAid, Amazon, Netflix, Pixar, Pinterest
There is no surprise that companies like Apple and Amazon has been consistently in the list over the past few years. What I find surprising though is the consistent appearance of a certain (in fact the only one) social media company in the list over these years. That company is not Facebook or Twitter. It is Pinterest. For those who are unfamiliar with Pinterest, it is an image sharing social media company which allows users to share and discover interests through "pinning" images on boards. There are some who claim that if you miss out on the growth of Facebook shares in its early days, you have a second opportunity in Pinterest. Pinterest was only listed in April 2019 and hence you can probably consider yourself as an early owner/buyer of the company shares if you own/buy them now. With regards to how attractive Pinterest is as an investment, I guess there's a story for another day.
Now, let's put forth a hypothetical scenario. What happens if you were to follow this index and only invest in the companies listed in this index? Could you have outperformed S&P500?
Let's take a look.
I did a simple scenario here where I start off with investing $8000 in two portfolios (one is solely in SPY, another on "Economic Moat Portfolio" which consist of the companies from the Prophet Relevance Index) from 2016 to the start of 2020. The SPY portfolio is a buy and hold portfolio while the "Economic Moat Portfolio" is a portfolio which I rebalance every year based on the companies listed in the Prophet Relevance Index in that particular year. Investment in the companies listed in the index are all equal. In scenarios where there are duplicates in the index (eg. Android and Google), no "double investments" will be made and they will be treated as one company. For simplicity sake, trading fees and currency exchange effects are ignored.
Here are the results.
The results are hardly surprising. If you were to invest in the "Economic Moat Portfolio", your initial $8000 investment will turn into ~$17200 (which is a CAGR of ~20%). If you were to invest solely in SPY, your initial $8000 investment will turn in ~$13000 (which is a CAGR of ~13%). Hence, it does seem at first glance that investing in companies listed in the Prophet Relevance Index does give you some sort of an advantage in your investments. Of course, one should also bear in mind that the phenomenal growth of Apple and Amazon share prices over those few years has a big contribution to the "Economic Moat Portfolio". Nonetheless, investing in companies listed in the Prophet Relevance Index seems like an interesting approach to me and I would probably explore this a bit deeper.
At the end of the day, I have no doubt that companies with an economic moat will have a better growth in its business and this will eventually translate to better growth in its share price compared to the broader market. The usual difficulty is how do you identify that a company has a particular economic moat before everyone else realises it? The sooner you identify that, the higher your potential returns will be from investing in that particular company. But I guess that is an area where we are all learning.
Till the next time.
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