Motley Fool Hidden Gems Investing - Hidden Moats

Episode Date: November 26, 2022

Some moats are obvious, like a fortress balance sheet or Live Nation’s ownership of the live music. Others are made on mountains that nobody else wants. If you look hard enough, you can find companies with unusual competitive advantages.  Motley Fool Canada’s Jim Gillies and Iain Butler join Ricky Mulvey to discuss: - What it means for a company to have a moat - Key metrics that can show whether a company has a competitive advantage - Moats in utility poles, engineering software, and gentlemen’s clubs Companies mentioned: ADSK, LYV, POOL, RICK, MO, STLJF Host: Ricky Mulvey Guests: Jim Gillies, Iain Butler Engineer: Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

Don't you wish you could just hit skip on the worst parts of your life? You know, the same way you can skip an ad? I get it. I'm Siaya and I live in Ice Cove. I've made some questionable decisions that didn't end up the way I planned. And today I'm still figuring it out. Somehow things usually get worse before they get better. Apparently, that's how I roll.

So bundle up and come along for the bumpy ride. Stream a new episode of North of North Tuesdays on CBC Gem. This is almost an example I mentioned earlier where they kind of took over a mountain no one else really knew they wanted. And you've built a really nice cash generated business on top of that. And then as long as management makes good capital allocation choices with the cash they generate, you can start getting some pretty decent returns. I'm Chris Hill, and that's Jim Gillies from Motley Fool Canada. Ricky Mulvey caught up with Jim and his colleague Ian Butler to talk about companies with unusual moats. Some competitive advantages are well

known, but let's face it, some economic moats just aren't that obvious, like utility poles, engineering software, even gentlemen's clubs. In this episode, Jim and Ian talk about what makes something a moat and the metrics that can reveal a true competitive advantage. There's a lot of ways that a company can create a moat, but I think that's really what it comes down to. It's just your ability to sustain a competitive advantage over a long period of time. Is there any other fancy definition or way of describing it in your mind? One that I like to refer to, I'm not sure it's ever been really in the textbooks, doesn't get equated to moats. Companies that go after industries that nobody else wants,

I think we've got a few examples of that planned for you today, but you took control of a mountain no one else knew they wanted. Then at the end of the day, you realize, oh, this company controls this subspace, it doesn't have to be something terribly exciting and sexy, internet security. Sometimes you can find it in some pretty weird little niche places that no one else realizes wasn't a great opportunity, except one or two companies basically go in and seal it up for themselves. We're going to get weird in a little bit. Jim, I remember in some previous conversations about franchise businesses, your personal fave, you've said that you're okay paying a higher multiple on a franchise business because you know that it's a reliable check

caching machine. How does a moat fit in your investing framework? Do you ever find yourself saying, you know what, it might be worth paying for this overvalued company on other metrics because it has such a wide moat? Well, one of the best things you can find, course, if you can find one of those widening or nascent or super wide moats, if you can find that for the bargain price, that's the holy grail. But yeah, one of the symptoms of a moat company for me is they can generally have pretty good carte blanche in raising their prices, controlling their prices. We talked briefly before the show, one example that I have is a private company, I know. But they can charge pretty much whatever they want because their customers,

when they talk to their customers, there's something like 0.001% of the typical company operating budget, so no one's going to care. They're just going to like, oh, if the supplier company decides to double or triple their price, the customers don't really notice. What ends up happening is moted companies, if I can use that as a word, moated companies tend to have pretty good pricing power, they tend to be very good cash generators, and then you hope they're good capital allocators of the cash they generate. I think to build a valuation case, I'm just trying to think through some examples that I've experienced over the past. I think you really have to get into the small-cap world to

find a valuation case when it comes to a moat, as opposed to these mega-cap companies certainly have moats, but valuation outside of crisis times in the market is rarely ever a reason to buy those companies. Autodesk is one that comes to mind. It's a recommendation that we've made in Stock Advisor Canada. It's in several services across Fulton. I wouldn't say there's a valuation case for Autodesk, but I would say that there's an incredibly strong moat associated with Autodesk, which I think in that case can overcome any valuation concerns that one might have. Yeah, just for some context, that's the one that a lot of, like, engineers use where if you're building out a building and you want to make sure that your electrical engineers and your plumbing folks are operating on the same system. What, Jim Gillies, what?

This is my engineering ring. As the former engineer on the panel, let me tell you that the AutoCAD moat is very, very real. It is basically all you learn to do. And if you want to have portability from one job to another in the engineering space, it's all Autodesk, it's all AutoCAD. It's difficult for the listeners to see. Sorry, I was just … I just saw you sticking a finger up at me, and luckily it was your pinky, and not the other one. Not that finger, not that finger. Well, I mean, you American

types don't wear engineering rings, but in Canada, the engineers, it's a supposedly solemn ceremony where there's a Rudyard Kipling poem. It's less serious than they make it out to be when you realize when you go in. It's supposed to be a commitment that engineers will not pass shoddy work, we'll do the best for the public, blah, blah, blah. Well, I want to talk about some obvious modes because there's some intro folks out there. I think it's a good way of illustrating how a company becomes essentially a mega cap or a larger cap company by just building either a balance sheet up or just a vertically integrated system. When I think of an obvious moat of a company, I think I would actually go to Live Nation. They own Ticketmaster,

they own the venues, they manage the ticket sales, they manage the artists. If Jim Gillies, you want to see Death Cab for Cutie, it's a very important band. It's not like it's easily substitutable for another jam band like Goose or the Den Company. You want to see Death Cab for QT. You're going through Live Nation. I am going. I have recently twice, yes. Then to your earlier point, Ian, though, it's something you're going to pay for. I think right now the stock is trading at about 100 times earnings or something like that. When you think of obvious moats, I know you got one on here, Ian, so I'll start with you. What is just an obvious fastball straight down the middle moat that you can think of?

The company that pops right into mind is only a company that I've come to know over the past year or so. I suspect that if indeed we have some relatively new investors listening, they will not have heard of it. It's a big company. I don't have the market cap up handy right now. A Dutch company by the name of ASML. ASML essentially is the ground floor in the entire global semiconductor industry. They make the machines that go into the manufacturers of semiconductors and thereby manufacture semiconductors. Intel is a client, Taiwan Semiconductor is a client. All these massive semiconductor companies are reliant on the machines that ASML makes and they have such a lead in technology. That lead is expanding as each new generation of machine comes out.

These are hugely expensive machines. I think they're nine-figure machines. For one, they sell like 30 machines in a year or something like that. It's really hard to imagine anyone, I don't even think anybody's even trying to compete with them. They're that far ahead and the capital is that intensive that it just doesn't make sense to compete with them. That's been a company that I've learned about, again, in the past couple of years that has just blown me away at its competitive strength and the depth of the moat there. All right. Let's move to some less obvious ones. I want to talk about pool equipment. You guys countered with rail ties and compressed wood. This is a company that makes utility poles,

which is a product that is quite literally grown on trees. We're talking about Stella Jones. Why is Stella Jones a company with a hidden moat? Well, it starts, yeah, if you want me to take the first kick out of it. It's a company that both Ian and I have recommended on our respective services in Canada. So, if nothing else, we apparently like railway ties and utility poles, which of course are there. And talking our own way. Yeah, exactly. I mean, but seriously, you get railway ties and utility poles, how excited are you, right? I think Ian calls them the national tree of Manitoba or something like that, the utility pool. Somebody once called driving through Nevada on a mining trip once,

that's what they pointed out, the telephone pole was the national tree in Nevada or the state tree in Nevada. But it's a moat for similar reasons to what I discussed earlier, where the dollar value of what they're putting in for railways. Railroads are massive massive, capital-intensive businesses. That's part of why Buffett went and bought a railway for Berkshire Hathaway, because we want to be able to reinvest tremendous amounts of capital at ideally high rates of return. But to maintain these networks, these massive networks is a lot of money per year. And the compressed wood, the creosote-soaked railway ties, they've been pretty much the same since the 1800s. I know there's concrete railway ties as

well. These are fairly simple, fairly localized, there's only a few companies that do this kind of stuff. Stella Jones happens to be, I believe, the largest one, certainly in North America. They are able to essentially pass along their cost plus in inflationary environments. No one's going to bat an eyelash, the big railway company is not going to bat an eyelash at what Stella Jones is requiring to have them pay. You essentially have, it's like the water chemistry example. Stella Jones can push through their price increases, maybe a little bit more for their pain and suffering, and the railway companies are just going to, yeah, okay, cool, that's fine. They're also not similarly going to, this is not a product that they're going to switch out for,

you know, a young upstart competitor in the creosote-soaked wood comes along and says, hey, we'll beat Stella Jones' prices by 5%. It's not going to go, because you're not going to switch back and forth, they're just going to go, no. And then on the utility side of things, quite often municipalities have multi-year contracts with Stella Jones to keep them supplied with the state tree of Nevada. I've always loved that line. It's a case of, this is a company that they've got products. This is an example almost a little bit of, we're going to get to better examples, but this is almost an example I mentioned earlier where they took over a mountain no one else really knew they wanted, and you built a really nice

cash generated to the business on top of that. Then as long as management makes good capital allocation choices with the cash they generate, you can start getting some pretty decent returns. I've always seen utility pulls as a commodity and to be honest, I haven't really seen utility pulls and thought much of them. Are there any real competitors in the space or is this a market share leader that has just completely claimed the mountain you just described? I think any competitors that are out there are minuscule in relation. They are sort of the big dog in the pound. Yeah. We've got a member of a couple of Fool services who we know because we've interacted a couple of times on Twitter,

and he does work for a competitor of one of, basically, they go out and harvest the trees. he's in the tree harvesting business, but for a competitor of Stella Jones. And he has only said in our brief conversations, he's only had positive things to say about Stella Jones and remarked on, they're a hard company to compete against. This is also a company, though, where growth is fairly predictable. They can project their revenue pretty well, I would assume. But it's also a case where the company's valuation has gotten ahead of itself before. So, for the old retail folks, what are the metrics to really watch with this company to make sure they're not paying too much for their utility pulls? It was one of the best performing

stocks in the Canadian market up until a few years ago when it's flattened a bit. That's right, the multiple has historically been very high. It's not high now and it hasn't been high for a couple of years. I think at worst, if you just can get this company for its growth prospects alone, for its consistent, as you say, predictable revenue stream, growing with inflation and whatever else, any contractual increases it can make, great. But I think there's a case right now, especially where there's potential multiple expansion involved. Historically, it's been it a 20, 25 times earnings type company, and here we are half that. I think there's a good total return equation in play right now. I think it's one too where you could probably

let it go when it does get more fairly valued. It doesn't necessarily have to be a buy and hold forever type of situation despite its competitive position. To build on that, the valuation I think is really something you want to watch this Modi company. And I think people should be aware of that they were doing very, very well on the Toronto Stock Exchange. And they kept on touting that, even though it kind of stopped after about 2015. The stock got very, everybody thought it was, so the company itself will put out a press release or a slide deck showing how, oh, they'd beaten the market, beat the S&P 500, they beat the capped industrial index and the S&P TSX. Then you look at how they

did it, it's like, well, but that's a 10-year chart. This is a nine-year chart where I was looking at it about a year ago. If you lopped off the first two years, all of a sudden, Stella Jones went from a market smasher to, I think, from about March of 2015 through to the end of 2021, I think its annualized return was about 0.7% because, to Ian's point, they had gotten out ahead of their skis valuation-wise, they'd become this darling. People forgot about them and the stock meandered down. When we were looking at them and recommended them, I don't remember what, Ian, you put them into Stock Advisor at, but by the time we came along to them, and I think we went first in GEMS, if I'm not mistaken. But Ian has talked about 25X earnings was where these

were hovering. By the time we came along to them, I think we are about 11X earnings. We got at a much better price and then as Ian says, we're looking for multiple expansions. Not only are they growing earnings and growing revenues and growing cash flows and paying you higher dividend and buying back stock, but maybe if they ever go back to that 25X multiple, we're going to get get 100%, 150% return on our cost basis, just from the multiple expansion, forget about the business growth. Maybe it doesn't sound great if you go back and look at the early 2021 growth stock frenzy, but historically, that's the apparition and the market we know grows 10%, 11% annualized with dividends reinvested. This suddenly becomes a very good argument

for buying Stella Jones at roughly the present valuation level. Next company could not be more different. This is a company that operates a chain of strip clubs, nightclubs, sports bars and restaurants. It's also a media and convention company that serves the adult club industry. It's RCI Hospitality, formerly known as Rick's Cabaret. Jim, when you presented this, first of all, I had to make sure it was okay for us to talk about the show. But second of all, when you presented this, I understand how this business is profitable, but what I don't understand with RCI Hospitality is how it has a moat when it has quite a few competitors. I'm going to suggest to you,

not only does it have a moat, it's got multiple moats. I do thank you for running it through the proper channels because it's a legal business, but I obviously understand that there could be disparate opinions about this type of business. And so, of course, no one has to own anything they're not personally morally comfortable with, of course. But in my particular town, where I live in Southern Ontario, there is one approved location for this type of business. And it's actually housed, it's not owned by RCI, but I'm going to get to why it applies to RCI here. It is owned by an individual. It's in a historically significant house for this town where I live. It's actually in a heritage building. And for the last two decades,

they've said to the city, we want to move out more to the industrial end of town kind of thing, and we would sell you the building. And the city says, we have grandfathered in, there will be no more of these types of businesses approved in this town. So, nothing has happened, and the place is still where it has been for decades. That's a kind of moat. Literally, if they close or move, that service will be gone from the city. And that's kind of what's going on for RCI. Quite often, they own the only approved, allowed, grandfathered-in locale for Gentleman's Entertainment Club. Strip club sounds so sorted. They literally have a localized government granted and enforced moat. They don't have to go out and advertise and try to

know, beat back the competition coming in and setting up across the street from them or across the road. Like, they're kind of legislated in, and so what ends up happening, a lot of these things have also been sole proprietorships, and RCI is going in and buying up the sole proprietorships or, you know, like, individual businesses. They're buying them up at relatively low valuations, because it's another example of, it's a mountain no one else realized they wanted, they're buying it three, four, and five times EBITDA when they take over someone looking to sell one of these locales. They go in, they pay a relatively low valuation, and they're grandfathered in. So, again, whether you agree with the business

model or not, and I certainly can see the arguments on both sides, to be honest with there is some value in a localized government-granted moat. One of the best-performing stocks in North America in the past 75 years is Altria, a.k.a. Philip Morris, a.k.a. the Marlboro cigarette people. One of the reasons why it's been so successful has been the tremendous external pressure against owning companies like that. So, it's kept it at a low valuation. That company as well, I mean, they don't have to advertise cigarettes anymore. They don't have a lot of R&D budget. They make a ton of cash. They pay a ton of taxes. They make a ton of cash. And they roll that cash continually into raising their dividend and buying back shares. And they do so

at a really low valuation because of the external pressure. And that's sort of what's kind of, I I mean, what's unsaid here is, since we started looking at RCI hospitality about two-and-a-half years ago, I think the stock is a seven-bagger, because that's the same kind of principle coming forward here. I said to Ian in the past, this is probably, even though given the controversial nature of the business, it's probably not one we want to recommend, but I think it's worth looking at for people who don't mind the morality of the business. I think it's worth looking at because I hold RCI Hospitality as probably got one of the best and most comprehensive,

well-thought-out plans for delivering their free cash flow, what they're going to do with their cash and their whole capital allocation stack. At this price, we're going to tuck in acquisitions. At this price, we're going to seek dividends and dividend hikes, maybe a special dividend. at this price, we want to be looking to buy back shares. I think they've done really, really well. The CEO is known as, he was a big fan of the book, The Outsiders, which is all about capital allocation and rockstar companies that have done well with it. He read that about five or six years ago and I think he embraced it as how he wants to run RCI hospitality. Again, you're focused, but there's a lot of real good positives that we would like with a lot of stocks in the Foolish

universe, but there is that kind of business that maybe no one else wants. That's an interesting combination to me. It's a company you want to ask questions about. Glassdoor ratings are always something that can be juiced and you want to look with a more critical eye, especially for smaller cap companies. 94% of employees would recommend working there to a friend. If this is your space, it sounds like it has an incredibly high employee score, I would say. Let's move on some final questions. I think the thing about moats, and we were talking about this earlier with some companies, is they can end up being stocks that you own but don't really pay attention to. That's exactly the case with a company like Pool Corp, which is not selling pool supplies

to consumers, but rather businesses. It's not a stock I own, but it's 20 times larger than its second competitor. That would give it, I would say, a pretty strong vote in a space, in a hill that not too many people else are at or on. Yeah, and it's definitely, I think I said before, I actually own it. And yeah, I couldn't tell you the last time I went and looked at their filings, just because it's not one that I worry too much about. I would encourage people who are interested in Pool Corp, go have a look at their historical returns, how they've done in terms of returns on capital, and then what they've delivered to shareholders. To long-term shareholders, again, this is not something that you should

be jumping in and out of, I think. Ian? Actually, you just raised a question that I threw into our notes. Do either of you key on a specific metric to provide some indication that a moat might be present? Is there any one number that you look to and go, this is an interesting competitive situation potentially. I'm honored you asked me, but I have no idea, so I'm just going to punt this to Jim. I'm going to say no, disappointingly. I'm a cash flow guy, so I look at cash. I think that's the answer. The two that came to mind when I was asking myself that question, as I was looking at some of these companies that we threw into the air, I think an improving operating margin

It indicates pricing power, potentially, and the ability to get more out of your customers and what you're having to put into the cost-wise. I wonder about return on equity as well, like, a high return on equity might be an indication that there's a favorable … Yeah, maybe more return on capital, especially in a world where we've seen a lot of companies blow up their balance sheets with buybacks, and yet that's going to keep your equity account low, it's going to float your ROE higher, So, more of a, maybe more of a return capital thing, I would argue for. But there's very much, I think maybe the message then is, it's a mosaic approach,

there's no real, like, one thing that any of us are going to point to and go, boom, moat. It's like, you got to kind of understand the business and the dynamics behind the business. I love the mosaic approach analogy, that's very Charlie Munger of you, I think that's where I first heard that one, I think that's great. Chris Hill. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.

Thank you.