Motley Fool Money - 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

Hi everyone, I'm Charlie Cox. Join us on Disney Plus as we talk with the cast and crew of Marvel Television's Daredevil Born Again. What haven't you gotten to do as Daredevil? Being the Avengers. Charlie and Vincent came to play. I get emotional when I think about it. One of the great finale of any episode we've ever done. We are going to play Truth or Daredevil.

What? Oh, boy. Fantastic. You guys go hard, man. Daredevil Born Again, official podcast Tuesdays, and stream Season 2 of Marvel Television's Daredevil Born Again on Disney Plus. This is almost an example I mentioned earlier where it's, you know, they kind of took over a mountain no one else really knew they wanted. And you built a really nice cash generator of business on top

of that. And then as long as management makes good capital allocations 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. I'm not sure it's ever been really, you know, the textbooks doesn't get equated to most. Companies that go after industries that nobody else wants. I think we've got a few examples of that plan for you today. But, you know, You took control of a mountain no one else knew they wanted. And then kind of at the end of the day, you kind of realize, oh, this company controls this subspace. It doesn't have to be something terribly exciting and sexy, you know, 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. Let's, look. We're going to get weird in a little bit. And I remember Jim, I remember in some previous conversations about franchise businesses, your personal fave, you've said that like, you're okay paying a higher multiple on a franchise business for, because you know that it's, it's a reliable check cashing machine. How does a moat fit in your investing framework? And 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, of 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, I'm fine. One of the symptoms of a moat company for me is they can generally have pretty good carte launch and 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 percent of the typical company operating budget. So no one's going to care, right? They're just going to like, oh, if the supplier company decides to double or triple their price, the customers don't really notice. And so what ends up happening is moated companies, if I can use that as a word, moted 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. And 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 like crisis times in the market is hardly, is rarely ever a reason to buy those companies. Auto Desk is one that comes to mind. It's a recommendation that we've made in Stock Advisor Canada. It's across several services across Fuldom.

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 sort of overcome the value, 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? As, 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 just saw you sticking a finger up at me and luckily it was pinkie and not the other one. Well, you American types don't wear engineering rings, but in Canada, the engineers, it's a supposedly solemn ceremony where we're all, you know, and there's a Rudd Rudyard Kipling poem and the big, it's less serious than they make it out to be when you realize when you go in, but it's still fairly. And 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. I want to talk about some obvious modes because there's some intro folks out there. And I think it's a good way of illustrating that how a company becomes essentially a mega cap or a larger cap company by just building either a huge, like a balance sheet up or just a vertically integrated system. When I think of an obvious mode, of a company, you know, 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. So if Jim Gillies, you want to see Death Cab for QDee, it's a very important band. It's not like it's easily substitutable for another jam band like

Goose or the Dend Company. You want to see Death Cab for Qty. You're going through Live Nation. I am going, and I have recently twice, yes. And then to your earlier point, Ian, though, it's something you're going to pay for. I think right now the stock's trading at about 100 times earnings or something like that. So, when you think of obvious modes, I know you got one on here, and Ian, so I'll start with you. What is an obvious, just an obvious fastball straight down the middle moat that you can think of? So the company that pops right into mind is only a company that I've come to know over the past year or so. So I suspect that if indeed we have some relatively new investors listening, they will not have

have heard of it. It's a big company. I don't have the market cap up handy right now. Dutch company by the name of ASML. And 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 manufacturer semiconductors. So Intel is a client. Taiwan semiconductor is a client. All these massive semiconductor companies are reliant. 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, 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. It just doesn't make sense to compete with them. So that's been a company that I've learned about again in the past couple 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? vote? Well, it starts. Yeah, if you want me to take the first kick out it, it's a company that both E 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. Yeah, exactly. I mean, but seriously, you know, you get railway ties and utility poles. How excited are you, right? Or what do you call you? I think Ian calls them the National Tree of Manitoba or something like that, the utility pull. Somebody once called, driving through Nevada on a mining trip once, that's what they, that's what was the telephone pole was the National Tree of Nevada, or the State Tree of 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,

massive capital-intensive businesses. That's part of why Buffett went and bought a railway for Berger-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, are, you know, they've been, what, pretty much the same since the 1800s. You know, this is not, I mean, I know there's concrete railway ties as well. You know, these are fairly simple, fairly localized. These are only a few companies that do this kind of stuff.

And Stella Jones, happens to be, I believe, the largest one, certainly North America. And they are able to essentially pass along their cost plus, you know, in inflationary environments, no one's going to bat an eyelash. The big railway company is not going to buy about an eyelash at what Stella Jones is requiring to have them. So you have them pay. So you essentially have, it's like the water chemistry example, you know, 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 and the Creosote soaked wood comes along and says, hey, we'll beat Stella Jones's prices by 5%. Yeah, this is not going to, it's not going to go because you're not going to switch back and forth. They're just going to go, no, Stella Jones is still kind of, 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. So it's a case of, this is a company that, you know, 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 it's, you know, they kind of took over a mountain no one else really knew they wanted. And you built a really nice cash generator to the business on top of that. And then as long as management makes good capital allocations choices with the cash they generate, you can start getting some pretty decent returns. Do they have any? Like, I've always seen utility poles as a commodity. And to be honest,

I haven't really seen utility polls and thought much of them. Is this something that like there Are there any real competitors in the space? Or is this like, 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 of Services who we know, because we've interacted a couple of times on Twitter. And he does work for a competitor of One of like basically, they go out and harvest the trees. He's in the tree harvesting business, but for a competitor of Stella Jones.

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 evaluation 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 poles? I think that's what's historically.

I mean, so it was one of the best performing stocks in the Canadian market up until sort of a few years ago when it's kind of flattened a bit. And that's right. The multiple has historically been very high. It's not high now and it hasn't been high for a couple years. So I think at worst, if you just can get this company for its growth prospects alone, for sort of 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 when there's potential multiple expansion involved. Historically, it's sort of a bit of 20, 25 times earnings type company, and here we are sort of half that. So I think there's a good total return equation in play right now. I think, and 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. Yeah. To build on that, the valuation, I think, is really something you want to watch for

this Modi company. And I think people should be aware of that, you know, they were a really 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, they'd beat the S&P 500, they'd beat the Cap Industrial Index and the S&P TSX. And then you kind of look at how they did it. It's like, well, but that's a 10-year chart. That was actually a nine-year chart where I was looking at it about a year ago.

And if you kind of lopped off the first two years, all of a sudden, Stella Jones went from a market, the smasher to, I think from about March of 2015 through to the end of 2021. I think its annualized return was about 0.7 percent, because to Ian's point, they had gotten out ahead of their skis valuation-wise. They'd really kind of, um, they'd really kind of, um, you They'd become this darling. And so people kind of forgot about them and the stock meandered down. And so when we were looking at them and recommended them, I can't, 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, you know, Ian has talked about, you know, 25 times earnings was kind of where these were hovering. By the time we came along to them, I think we were about 11 times earnings. So we got it a much better price. as Ian says, we're looking for multiple expansions. So not only are they growing earnings and growing revenues and growing cash flows and paying you a higher dividend and buying back stock, but maybe if they ever go back to that 25 times multiple, we're going to get 100, 150 percent return on our cost basis just from the multiple expansion.

Forget about the business growth. And maybe it doesn't sound great if you go back and look at the 2020, early 2021, one, you know, kind of growth stock frenzy. But historically, you know, that was, that's the apparition in the market we know grows 10, 11 percent 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, 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. 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 on 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. And I do thank you for kind of 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. Okay. It's actually housed. It's not owned by RCI, but I'm going to get to why it. I mean, 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. Okay. It's actually an heritage building.

And for the last two decades, they've said to the city, we want to move out to more to the industrial ends of town kind of thing. And we would sell you the business. And we would sell you the business. or 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. They quite often only, They own the only approved, allowed grandfathered-in locale for gentlemen's entertainment club kind of thing. Strip club sounds so sorted. And so they literally have a localized government

granted and enforced moat. They don't have to go out and advertise and try to beat back the competition coming in and setting up across the street from them or across the, 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 Ibeda when they take over someone looking to sell one of these locales, they go in, they pay relatively low valuation and their 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 you, there is some value in a localized government-granted moat. And one of the arguments, one of the best performing stocks in North America in the past, 75 years is Altria, aka Philip Morris, aka the Marlboro cigarette people. And 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 at a low valuation, that company as well.

I mean, you know, they don't have to advertise cigarettes anymore. You know, they don't have a lot of R&D budget. You know, 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. That's sort of what's kind of, I mean, what's unsaid here is since we started looking at the RCI hospitality about two and a half years ago, I think the stock is Sevenbacker. Because that's the same kind of principle coming forward here is they, 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 kind of 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 in their whole capital allocation stack. So, you know, at this price, we're going to seek, you know, 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 buyback shares. And I think they've done really, really well. The CEO is known as a, he was a big fan of the book, The Outsiders, which is all about capital allocation and rock star companies that have done well with it. And he kind of, you know, he read that about five or six years ago. And I think he kind of embraced it as how he wants to run RCI hospitality. And so, again, you're kind of focused with there's a lot of real good positives that we would like with a lot with a lot of stocks in the Foolish universe. But there is that kind of business that maybe no one else wants.

And so you kind of go, that's a, that's an interesting combination to me. It's a company you want to ask questions about. And Glassdoor ratings are always something that can be juiced and you want to look with a more critical lie, especially for a smaller cap companies. 94% of employees would recommend working there to a friend. So, if this is your space, it sounds like it has an incredibly high employee score, I would say. Let's move on to some final questions. I think the thing about MOTS, 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.

And that's exactly the case with a company like Pool Corp, which is not selling pool supplies to consumers, but rather businesses. And it's not a stock I own, but it's 20 times larger than its second competitor. And 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. It's been to long-term shareholders. Again, this is not a, this is not something that you should be jumping in and out of, I think. Ian? And actually, you just raised a question that I threw into our notes ahead of the. Do either of you sort of key on a specific metric to sort of provide some indication that a moat might be present? Is there any one number that you sort of look to and go, hmm, this is an interesting competitive situation potentially? I'm honored you asked me, but I have no idea. So I'm just going to, I'm going to

punt this to Jim. And I'm going to say no, disappointingly. Yeah. I just, I'm a cash flow guy, right? 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 margin is one, an improving operating margin. It indicates pricing power potentially and ability to sort of get more out of your customer.

and what you're having to put into the cost-wise. I wonder about return on equity as well. A high return on equity might be an indication that there's a favorite. Maybe more return on capital because especially in a world where we've seen a lot of companies kind of blow up their balance sheets with buybacks and yet that's going to keep your equity account low and it's going to float your ROE higher. So, more of a, maybe more of a return capital thing I would argue for. But it's, but it is, there's very much, I think that, I think maybe the message is, then is, it's a mosaic approach. There's no real like one one like thing that we, 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 dynamic behind the business. I love the mosaic approach analogy. That's a very, very, very Charlie Munger of you. I think that's where I first heard that one. I think that's great. 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.