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MOATS: PROTECTION FROM BARBARIANS AT THE GATES

10 March 2016 | by Arif Karim, CFA
Earlier this week WE DISCUSSED the quality first approach we use in our investment
process at Ensemble Capital. In that post we mentioned the concept of a “moat”. Let’s
explore this concept a bit more.
In medieval times, moats were the bodies of water surrounding castles used to protect
against invaders.
Bodiam Castle, Scotland Source: ANTARCTICAEDU.COM
In a time dominated by foot soldiers and horses, the moat provided a good defense
against the threat of pillaging invaders while allowing the castle’s resources to be
channeled towards a limited entry point that made defending it a lot easier. The
medieval times were a barbaric period in human history when resources were very
limited and it was fair game for one group to try to take them from another to survive,
with the strongest capturing or retaining the spoils of battle.

Capitalism is still barbaric. When a company finds a place in the economy to earn a
profit, there are many other companies that will try to take a piece of the action.
Without some type of profit protecting business model characteristics, businesses with
attractive returns are likely to be bled out by competitive assaults until returns fall
towards some industry average, resulting in just average profits over the long term.

We see examples of this brutal competition occur in cycles broadly across the airline,
auto, insurance, clothing, steel, technology, and most other industries where there exists
little differentiation between the products and services beyond some short period of
time. Most businesses facing this daily reality will have a hard time earning strong
returns and, therefore, represent an average business at best with average investor
returns.

Fortunately, there are a select few companies that have managed to build strong
defenses around their businesses, either with their own activity, due to the structure of
their targeted business/market, or with the help of external forces such as regulation,
that enable them to earn strong rates of returns over long periods of time.
 The moat analogy has often been cited by Warren Buffett, who has emphasizes the role
of moats in his investment selection and acquisition candidates. When his favorite
investment horizon is “forever”, it’s the moat (1 st ) and management (2 nd ) shepherding
the business that deems a company worthy of his ownership (but only if it can be
bought at a “fair” price or better). The moat allows the company to earn excess returns
in its business while the duration of the moat advantage allows the company/investment
to compound the value of the excess returns over time.
Additionally, if a strong moat exists, then any particular quarterly reported number is
very unlikely to mean much at all in the overall long-term value of the company,
whether positive or negative, despite Wall Street’s short -term excitement over these
reports.

The Morningstar team has published a great book detailing how to analyze moats
called WHY MOATS MATTER. In it, they cite a wonderful example of Proctor &
Gamble’s moat weakening after a new CEO made changes in its R&D efforts beginning
in 2000 that resulted in only a 0.7% drop in one of P&G’s most high-profile product
categories, laundry detergent, from 2007 to 2012. In other words, the strength of P&G’s
moat was so strong that it took five years to lose less than 1% of market share to
competitors despite management’s reported mis-execution for a decade! That is the
buffer a moat provides a company against encroachments into its high -return turf.
Sources of moats can generally be characterized as:

 Intangible Assets including patents, brands, reputation, trade secrets, proprietary

business processes and other sources of advantage that make it difficult for competitors
to enter into a market or charge enough to earn a high enough profit or take meaningful
share. Classic examples of this are Apple (APPL), Tiffany (TIF), and Pepsi (PEP)
among our portfolio names.
 Low Cost/Scale Advantage that allows only a limited number of players in an industry
to be the low-cost supplier(s) that then allow these players to enjoy higher profits than
competitors because of their wider margins and/or grow to take more of the market
profits because they can undercut rivals while still earning profits. Examp les of this are
retailers like Costco (COST), Amazon (AMZN), and Walmart (WMT).
 High Switching Costs that make it overly costly, risky, or inconvenient for customers
to switch from one vendor to another due to the long-term life of products, steep
learning costs, a non-insignificant risk of failure with a new vendor, or simply
behavioral inertia. Classic examples of these are software vendors such as Microsoft,
Oracle, and Apple or mission critical business services like Paychex (PAYX) and
Broadridge (BR).
 Network Effect is the phenomenon when the value of a service or product becomes
more compelling as more people use it. A great example of this is the telephone and the
Internet or a credit card network like MasterCard (MA)/VISA (V) or search/social
advertising networks like Google (GOOGL)/Facebook (FB). The more people use the
 product, the more valuable it becomes to everyone already using it because they get
increasing value from it.
 Regulation can provide protection for some period of time either explicitly, as with
drug patent regulation, or in a more general way that makes the cost of entry (monetary
or otherwise) too high for new competitors. Drug and medical device companies, such
as Intuitive Surgical (ISRG), or airplane parts suppliers, such as Transdigm (TDG), get
a strong advantage in protecting their businesses as a result of the regulatory approvals
competitors have to earn in order to compete.
Ideally, a company has multiple moat characteristics that allow it high barriers across
multiple fronts. For example, Apple has trade secrets involved in its design and
manufacturing approaches, patents to protect some of its innovations, a strong brand
that signals quality and status, scale to exert significant price control over its suppliers
and its retail/service provider partners, and high switching costs among its customers
who are embedded in its services ecosystem and have learned to habitually use its
products. The results speak for themselves.

(Click on image to enlarge)

It’s up to the investor to determine if there exists a moat and what the quality of the
moat is for any particular company. The stronger and more durable the moat, the higher
the likelihood that a company can earn and compound high rates of return above market
rates by fending off competition from eating into its business. This is likely to increase
the odds that the investor can earn a better than average long-term rate of return while
minimizing risk.

Discovering and evaluating these strong moat companies is the first and most important
step in our investment process at Ensemble and we believe it is the key to our long -term
investment strategy.

Ensemble Capital’s clients own shares of Alphabet, Inc. (GOOGL/GOOG), Apple Inc
(AAPL), Broadridge Financial Solutions Inc. (BR), Intuitive Surgical, Inc. (ISRG),
MasterCard, Inc (MA) Paychex, Inc (PAYX), PepsiCo, Inc. (PEP), Costco Wholesale
Corp (COST), Tiffany & Co. and TransDigm Group, Inc. (TDG).
 While we do not accept public comments on this blog for compliance reasons, we
encourage readers to CONTACT USwith their thoughts.
The information contained in this post represents Ensemble Capital Management’s
general opinions and should not be construed as personalized or individualized
investment, financial, tax, legal, or other advice. No advisor/client relationship is
created by your access of this site. Past performance is no guarantee of future results.
All investments in securities carry risks, including the risk of losing one’s
entire investment. If a security discussed in this blog entry is owned by Ensemble
Capital or one or more of its clients you will find a disclosure regarding the security
held above. Should Ensemble Capital subsequently purchase or sell any position in a
security discussed in this blog entry, we will not update the above disclosure nor revise
any archived blog entry after the date it is originally posted. If reviewing this blog
entry after its original post date, please refer to our current 13F filing or contact us for
a current or past copy of such filing. Each quarter we file a 13F report of holdings,
which discloses all of our reportable client holdings. Ensemble Capital is a
discretionary investment manager and does not make “recommendations” of securities.
Nothing contained within this post (including any content we link to or other 3 rd party
content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell
any securities or other financial instrument.

See all posts


 ABOUT THE AUTHORS

SEAN STANNARD-STOCKTON, CFA

Sean is president and chief investment officer of Ensemble Capital.
SEAN'S LINKEDIN PROFILE
ARIF KARIM, CFA
Arif is a senior investment analyst at Ensemble Capital.
ARIF'S LINKEDIN PROFILE

LUDO THOMASSON, CFP®

Ludo is Ensemble Capital’s director of wealth management.
LUDO'S LINKEDIN PROFILE

PAUL PERRINO, CFA

Paul is a portfolio manager at Ensemble Capital.
 PAUL'S LINKEDIN PROFILE
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 SEARCH
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The content provided on this website is for informational purposes only, and investors should not
construe any such information or other content as legal, tax, investment, financial, or other
advice. Nothing contained on this website constitutes a solicitation, recommendation,
endorsement, or offer by Ensemble Capital or any third party service provider to buy or sell any
securities or other financial instruments in this or in in any other jurisdiction in which such
solicitation or offer would be unlawful under the securities laws of such jurisdiction.

All content on this website is information of a general nature and does not address the particular
financial circumstances of any particular prospective individual or entity investor. Nothing in
this website constitutes professional and/or financial advice, nor does any information on this
website constitute a comprehensive or complete statement of the matters discussed. Neither
Ensemble Capital nor its advisors becomes a fiduciary by virtue of any person’s use of or access
to this website or any content herein. Prospective investors alone assume the sole responsibility
of evaluating the merits and risks associated with the use of any information or other content on
the website before making any decisions based on such information or other content. In
exchange for using the website, you agree not to hold Ensemble Capital, its advisors and
affiliates or any third party service provider liable for any possible claim for damages arising
from any decision you make based on information or other content made available to you
through the website.

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HOW MOATS MAKE A DIFFERENCE

4 April 2017 | by Sean Stannard-Stockton, CFA
In our writing here we’ve made clear the the single most important element of our
investment approach is focusing on companies that have A WIDE COMPETITIVE
MOAT. Usually when people talk about different kinds of moats, they are referring to
the elements of the business model that give rise to the company’s competitive
advantages. These concepts, like being the low cost producer, having proprietary
intellectual property or exhibiting network effects, have been well documented by many
writers. Morningstar’s book WHY MOATS MATTER offers an excellent overview. But
just as important is the different types of opportunities that different types of moats can
afford companies.
Our friend CONNOR LEONARD who runs the public market portfolio at INVESTORS
MANAGEMENT CORPORATION has developed an excellent framework for thinking
about moat outcomes.

Connor explained his thinking in two posts on Base Hit Investing last year, which you
can read HERE and HERE. Here’s a quick overview:
 Low/No Moat: Companies that may be perfectly well run and sell good
products/services, but which do not exhibit characteristics that prevent other companies
from competing away there profits if they start earning attractive returns. Most
companies fall into this category.

 Legacy Moat-Dividend: A company that is insulated from competition, but does not
have much opportunity to grow through reinvesting cash flow. So they pay most of their
cash earnings out as dividends.

 Legacy Moat-Outsider: A company that is insulated from competition, but does not
have much opportunity to grow through reinvesting cash flow. So they deploy their ca sh
flow in service of acquiring other companies as well as paying dividends and
opportunistically buying back stock, as described in the book THE OUTSIDERS.
 Reinvestment Moat: A company that is insulated from competition and has the
opportunity to reinvest their cash flow into growing the business.

 Capital-Light Compounder: A company that is insulated from competition and has the
opportunity to grow, but which doesn’t need to reinvest much cash to do so and is
therefore able to return cash to shareholders even while growing.
Our approach to investing is very similar to Connor’s and we thought it would be worth
looking at our approach and portfolio holdings through his framework.

Low/No Moat
We strive to avoid investments in this category. Morningstar, which rates companies
based on an assessment of the quality of their moat, only assigns a Wide Moat rating
(their top rating) to 10% OF THE COMPANIES THEY COVER. But they assign the
Wide rating to about 67% of the stocks in our portfolio and give a Narrow moat rating
to another 28% (these percentages exclude the few companies in our portfolio that they
do not cover).
We believe that Low/No Moat companies are so subject to the competitive nature of the
markets in which they operate that their future is far more governed by luck than by
conditions within their control. There’s no doubt that the stocks of these companies can
experience periods of fantastic performance. And those that are in the right place at the
right time can generate massive returns for shareholders. But we systematically avoid
investing in these companies because we don’t believe we have any particular edge in
understanding when is the best time to own them.

Note that Morningstar does rate our holding in National Oilwell Varco (NOV) as having
No Moat. However, until 2015 they rated the company as having a Wide Moat. As oil
prices fell, they downgraded the rating first to Narrow and then final to No Moat as a
new analyst picked up coverage. We believe that this analysis is flawed.

Legacy Moat-Dividend
Even if a business does have a moat, they might not have much of an opportunity to
reinvest more capital that is protected from competition. Plenty of companies make the
mistake of using their cash flow to get into entirely new businesses or throw more
capital against the wall hoping they can extend the life of their moat. But smart
management teams recognize this sort of moat as an opportunity to milk cash flow out
of the business in the form of dividends while simply maintaining, rather than
expanding the business. Think of this sort of business as like a toll bridge connecting
two busy cities. Building more toll bridges is futile, but so long as the number of people
wanting to cross the bridge is steady, the business can throw off lots of cash in the form
of dividends and is clearly valuable.

We don’t invest in many of these businesses as the “yield sign” in Connor’s framework
suggests. But these sorts of businesses can make sense if the stock price is cheap
enough. The closest to this type of holding in our portfolio is Pepsi (PEP), which over
the last three years has returned more than 90% of its net income to shareholders in the
form of dividends and share buybacks. But we think that Pepsi also has more growth
potential than investors give it credit for and is thus a hybrid between a Capital-Light
Compounder (see below) and a Legacy Moat-Dividend company.

Legacy Moat-Outsider
The book THE OUTSIDERS by William Thorndike is probably one of the most
influential investing books of recent years, in no small part beca use it was
recommended by Warren Buffett in one of his annual letters. The book is a series of
case studies that describes how a small number of CEOs have used cash generative
businesses as platforms to drive massive returns for shareholders by directing e xcess
cash opportunistically between large stock buybacks, special dividends and acquisitions
of other businesses. While studies show that mergers and acquisitions as a group
are value neutral or negative for shareholders (on average the selling company ge ts all
the excess returns), The Outsiders explored how some management teams focused on
driving shareholder value with their M&A rather than simply using it as a mechanism to
get bigger, have shown extraordinary success.
This category includes companies that have strong moats around their current business,
but rather than simply paying out excess cash to shareholders they deploy cash
opportunistically across various strategies, including mergers and acquisitions. In our
portfolio, TransDigm (TDG) is the clearest example of this strategy and in fact the
company was briefly mentioned by Thorndike in his book.

At Ensemble we do not focus on this type of business and believe that the bar for a
management team to demonstrate the ability to execute this approach is so high that it is
a relatively special situation and there are not a large number of these sorts of
investment opportunities.

Reinvestment Moat
This sort of moat characterizes many large, high quality growth companies. A
Reinvestment Moat company has the strong competitive advantages around their core
business as seen in the Legacy Moats, but their market is not yet saturated and the
company has the ability to reinvest the cash they generate into growing. One classic
case of this sort of business is Home Depot in the 1990s. The company was pioneering
the home improvement big box business model and from 1990 to 2000 was able to
growth revenue from $2.8 bil to $38.4 bil (30% annualized growth), while net income
went from $112 mil to $2.3 bil (35% annualized growth). It was able to do this because
its business had solid returns on capital and the market was large enough that the
company was able to reinvest all of the cash it was able to generate while borrowing
even more money to fuel its growth.

Most businesses don’t have this opportunity. Returns on their existing business may be
strong, but most companies don’t have the opportunity to reinvest their earnings at
similarly attractive rates. Historically, public US companies have generated an average
return on invested capital of 10%, yet have only been able to reinvest about half of their
earnings at similar rates. So companies that can earn higher rat es of returns on both
their base business and new business are uncommon.

Our portfolio holds companies such as First Republic (FRC), Alphabet (GOOGL) and
Tiffany & Co (TIF) that exhibit these characteristics. In each case, the company
generates strong returns, needs to reinvest their earnings to fuel growth and has the
opportunity to do so. However, compared to Home Depot which was reinvesting more
than 100% of earnings to fuel growth, the capital requirements of growing First
Republic, Google and Tiffany still leave room for the companies to pay a dividend or
buy back stock. This feature is something we find highly attractive in the businesses we
own and leads us to the moat type that is most prevalent in our portfolio…

Capital Light Compounders

A Capital Light Compounder is a business which exhibits strong competitive
advantages and has significant growth opportunities, but which does not need much
capital to pursue growth. We view these as dream businesses. They earn good returns
today and they have the opportunity to grow materially in the years ahead. But they
earn such strong returns on capital that they tend to always have cash pouring out of
their business, even when growing rapidly or during recessions.

This wonderful situation means the businesses are resilient during difficult
environments where they have plenty of cash on hand to go after opportunities just at
the time when their competitors are forced to play defense. During good times, these
businesses can pursue their core growth opportunity, whi le also paying dividends,
buying back stock opportunistically or executing an acquisition when an attractive
situation presents itself.

In our portfolio, companies such as Paycheck (PAYX), Advisory Board Company

(ABCO), Broadridge Financial (BR), Landstar Systems (LSTR) and MasterCard (MA)
are all good examples. These businesses generate returns on invested capital in the
range of 30% to over 100% while simultaneously having the potential to grow earnings
at annual rates from 8% to 14%. This ability to generate returns on each new dollar of
capital they invest at rates of up to 10x better than the average company while growing
at rates approaching 3x the average public company makes these businesses very
valuable.

The fact that these businesses are so valuable (in short, because they can grow quickly
while returning lots of cash to shareholders at the same time) means that these stocks
often do not look statistically cheap on simplistic measures like PE ratios. This leads to
value investors often ignoring them believing they are too expense, while growth
investors will often only be excited during the early stages of rapid growth but lose
interest when the growth rate slows to solid, but not exciting, levels.

We think that Connor’s framework for thinking about the benefits of moats is an
important complement to frameworks that explore the various strategies that give rise to
moats. A moat that allows a company to protect its profits and pay them out to
shareholders is quite valuable. One that presents an opport unity to reinvest earnings at
solid rates is even better. A moat that allows a company to do both at the same time
creates a cash generating machine that we search far and wide to find.

Ensemble Capital’s clients own shares of Advisory Board Company (ABCO), Alphabet
(GOOGL), Broadridge Financial (BR), First Republic (FRC), Landstar Systems (LSTR),
MasterCard (MA), Paychex (PAYX), Pepsi (PEP), Tiffany & Co (TIF), and TransDigm
(TDG).
While we do not accept public comments on this blog for compliance reasons, we
encourage readers to CONTACT USwith their thoughts.
The information contained in this post represents Ensemble Capital Management’s
general opinions and should not be construed as personalized or individualized
investment, financial, tax, legal, or other advice. No advisor/client relationship is
created by your access of this site. Past performance is no guarantee of future results.
All investments in securities carry risks, including the risk of losing one’s
entire investment. If a security discussed in this blog entry is owned by Ensemble
Capital or one or more of its clients you will find a disclosure regarding the security
held above. Should Ensemble Capital subsequently purchase or sell any position in a
security discussed in this blog entry, we will not update the above disclosure nor revise
any archived blog entry after the date it is originally posted. If reviewing this blog
entry after its original post date, please refer to our current 13F filing or contact us for
a current or past copy of such filing. Each quarter we file a 13F report of holdings,
which discloses all of our reportable client holdings. Ensemble Capital is a
discretionary investment manager and does not make “recommendations” of securities.
Nothing contained within this post (including any content we link to or other 3 rd party
content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell
any securities or other financial instrument.

See all posts


 ABOUT THE AUTHORS

SEAN STANNARD-STOCKTON, CFA

Sean is president and chief investment officer of Ensemble Capital.
SEAN'S LINKEDIN PROFILE

ARIF KARIM, CFA

Arif is a senior investment analyst at Ensemble Capital.
ARIF'S LINKEDIN PROFILE
 LUDO THOMASSON, CFP®
Ludo is Ensemble Capital’s director of wealth management.
LUDO'S LINKEDIN PROFILE

PAUL PERRINO, CFA

Paul is a portfolio manager at Ensemble Capital.

PAUL'S LINKEDIN PROFILE

 ARCHIVES
o THIRD QUARTER 2017
o SECOND QUARTER 2017
o FIRST QUARTER 2017
o FOURTH QUARTER 2016
o THIRD QUARTER 2016
o SECOND QUARTER 2016
o FIRST QUARTER 2016
o FOURTH QUARTER 2015
 SEARCH
 SUBSCRIBE TO UPDATES
The content provided on this website is for informational purposes only, and investors should not
construe any such information or other content as legal, tax, investment, financial, or other
advice. Nothing contained on this website constitutes a solicitation, recommendation,
endorsement, or offer by Ensemble Capital or any third party service provider to buy or sell any
securities or other financial instruments in this or in in any other jurisdiction in which such
solicitation or offer would be unlawful under the securities laws of such jurisdiction.

All content on this website is information of a general nature and does not address the particular
financial circumstances of any particular prospective individual or entity investor. Nothing in
this website constitutes professional and/or financial advice, nor does any information on this
website constitute a comprehensive or complete statement of the matters discussed. Neither
Ensemble Capital nor its advisors becomes a fiduciary by virtue of any person’s use of or access
to this website or any content herein. Prospective investors alone assume the sole responsibility
of evaluating the merits and risks associated with the use of any information or other content on
the website before making any decisions based on such information or other content. In
exchange for using the website, you agree not to hold Ensemble Capital, its advisors and
affiliates or any third party service provider liable for any possible claim for damages arising
from any decision you make based on information or other content made available to you
through the website.