WWII 079: Economic Moats Around Great Companies, Reverse Stock Splits, Buying Silver

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Main Topic: Economic Moats Around Great Companies

Warren Buffett said “In business, I look for economic castles protected by
unbreachable ‘moats’.”

This episode is about different kinds of the “unbreachable moats” Buffett was talking about in that quote.

In the days of yore, or days of old, olden times, etc, a castle was protected by a moat that circled it and could only be entered by a drawbridge. In times where an enemy approached the castle, the drawbridge would be raised and any attacking army would have to somehow cross the moat to enter the castle.

Here are the four main types of moats that can be found in public companies:

1. High switching costs. The moat here is a type of customer “stickiness”. The costs incurred to switch from one service or product to a competitor is so painful or costly that such switching is rare. This give the company pricing power, the ability to raise prices on a customer and the customer just taking it on the chin.

One industry with high switching costs is payroll processing. Companies like Automatic Data Processing and Paychex are business outsourcing companies. They handle handle human resource needs, payroll, computing processes, direct deposits, tax reports, employee time and attendance, hiring services, record-keeping, and some other software services. ADP is five times larger than their largest direct competitor. The company has more than three decades of consecutive annual dividend growth, and is one of only four non-financial U.S. companies with an AAA credit rating.

AT&T (T) is a large telecommunications company that provides wireless data/voice services, wired data/voice services, and advertising publishing. Switching costs are low-to-moderate for consumers, because contracts are often signed but can be fairly easily switched away from at expiration. Switching costs for businesses are more substantial; both wireless and wired services are rather “sticky” with business customers.

2. Low-Cost Producer. Companies that can deliver their goods or services at a low cost, typically due to economies of scale, have a distinct competitive advantage because they can undercut their rivals on price.

Southwest Airlines is a great example of an under-appreciated low cost producer. Southwest, unlike most of the major airlines, has never gone bankrupt. Their entire business model is based on being to lowest cost producer of airline miles so they can charge the least per seat per flight of any airline.

Another example of a low cost producer was Dell computer. Dell’s online-based direct sales and superior supply chain business model allowed it to produce custom PCs for far less than competitors.

3. Intangible Assets can be a major competitive advantage. If you have intellectual property that no other competitor can get, you have a potentially indefinite moat. Intangibles are things such as intellectual property rights (patents, trademarks, and copyrights), government approvals, brand names, a unique company culture, or a geographic advantage.

For an example that pretty much covers all possible intangible asset advantages, look no further than the Walt Disney Company. Disney has a catalogue of characters, movies, and assets that will never be replicated again. After gobbling up the Star Wars and Marvel universes, Disney has assets they can pull from for hundreds of years of content. They also control real estate like Disneylands all over the world that will never be created again. They have an countable treasure trove of patents, trademarks, copyrights to go along with everything else.

4. The Network Effect. The network effect is one of the most powerful competitive advantages, and it is also one of the easiest to spot. The network effect occurs when the value of a particular good or service increases for both new and existing users as more people use that good or service.

This kind of moat has been around for a very long time but became more prominent with the rise of the internet based social media companies. Network effects become significant after critical mass has been achieved. Critical mass is the point at which the value obtained from the good or service is greater than the price paid for it. There are a really only two ways in which a company can obtain critical mass:

(1) via incentives - e.g., offering free products in exchange for signing up or offering referral fees

(2) via value creation - e.g., creating a network that offers value to its visitors so great that its visitors not only come back to the network but they invite others to come back as well.

One of the earliest examples was the creation of the telephone. If you didn’t have one, you were out of the loop, so there was strong incentive to have one to become part of the network.

Modern versions of companies with strong network effects are Facebook, Yelp, Ebay and Amazon. This does not mean that network effects lead to profits, however. If you find a company that is very profitable and enjoys the network effect, you may have stumbled onto something big.

First, why are moats important? The simple answer is: competition. Buffett looks for business that cannot fall prey to competition. Any industry with low barriers to entry will ultimately become a low margin business as competitive destruction occurs. Buffett wants to buy companies that can grow cash flow indefinitely because competition cannot erode their ability to grow and protect margins.

Ask JB: What happens when a company does a reverse stock split?

A start up company I am looking at halted trading, made an acquisition, did a reverse split on its stock, and resumed trading.

However, my online bank shows that it hasn't resumed trading, and that my purchase price was the original that I bought it for, but I only own the amount that would make sense after the reverse split.

I was under the impression that under a reverse split, I keep my value, by the purchase price adjusting to the reverse split price, am I wrong here?

JB SAYS: You are right. In an reverse split, you have fewer shares, but each share is worth as much in underlying value as before. It really makes no difference to shareholders. For listed companies, it will help them stay listed, and now that they are not penny stocks, they may become eligible for holding by mutual funds which could create demand for the stock. If the underlying financial performance is terrible, however, it’s possible that the new stock will fall in price anyway.

ASK JB questions about investing in silver troy ounces for my infant son (self.investing_discussion)

submitted 26 days ago * by TheKoi

I've been buying American silver dollars (one troy ounce of silver but still legal currency) for my son for when he graduates high school for him to have to do with as he sees fit,whether for college or a job venture etc. I found a site that will sell you 10 ounces of regular silver rounds at base price one time only free shipping.you usually have to pay a bit over spot so they make a profit. is this a decent investment? thank you for your time and knowledge.

JB Says: Investing in precious metals is essentially relying on the great fool theory to experience any kind of appreciation. Gold and silver are priced based largely on other people’ desire for it. Worse, gold and silver cost money to store and protect, and do not pay growing rent, growing dividends, interest income. If you are going to invest for your child, I would much rather you buy a number of great companies over time. These will result in growth in shareholder value over time and put your child in a much better position financially in the end.

Do you have a burning question on investing you would like answered? Click the button below to send it to me and I will answer it on the podcast!

News: Amazon deal to buy Whole Foods sets off correction in packaged foods stocks

DISCLOSURES: I/We are Long Disney and Hershey

Thoughts on this podcast? Disagree with me on some point? Something I missed? Leave a comment!

About the Author

Jeremy Scott Bailey is an investor, author, entrepreneur and host of the "What Works In Investing?" podcast now available on iTunes. He is founder and Chief Investment Officer of Burgeón Group, Inc. an investment advisory firm that provides portfolio management services to families and individuals.

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