Motley Fool Money - The Might (and Myths) of Economic Moats

Starting point is 00:00:03 The might and myths of economic modes. Motley Fool Hidden Gems Investing starts now. Welcome to Motley Fool Hidden Gems Investing. I'm your host, and today we're going to change things up a little bit. As we're taping, this is actually a pre-record because as you're hearing this, we are all at Fool Fest, which is an annual live gathering of Motley Fool members. We do a lot of Q&A and things like that, and several of us, as well as a production team, are going to be there, so we needed to get something to you guys.

Starting point is 00:00:34 So this is a pre-recorded idea. I'm with John Kwasse and Lou Whiteman, as always. And what we're going to do is we're going to talk about the concept of economic modes. It is a very common or a very well-tread term that's used in financial media a lot as a way to analyze businesses. It became very popular in the 2000s. I think, John, you're going to talk about that a little bit. But I think for most beginner investors, understanding economic modes, what they're good for, why they might not be so good. and maybe some examples that will help kind of guide people into how to use this,

Starting point is 00:01:10 be a little bit helpful for them and a great kind of evergreen content we can do. So, John, I want to start with you because you were talking about a book, and I've actually got it. We can use it on video here. When you hear economic moats, what exactly are they? Yeah, a economic moat, this is basically something that a business has that makes it harder for the competition to compete against it. Pat Dorsey wrote a great little book called The Little Book That Builds Wealth.

Starting point is 00:01:39 And in that book, it identifies four different kinds of motes. I think this is a great book to read if you're a newer investor in particular. But the four categories that Dorsey identified was first intangible assets. So this could be like your brand, for example. It's not something that exists on a spreadsheet. It just kind of exists out there intangibly. So an intangible asset can be a moat, switching costs. So how painful is it to switch my business from from this company to that company, switching costs, network effects.

Starting point is 00:02:15 Think of a marketplace that has buyers and sellers. That's a network. A larger network is a greater kind of advantage. And then there's also cost advantages. So some companies can actually, for example, build their product for cheaper than a competitor for X, Y, Z. fill in the blank. So these things make it harder for other companies to come in and compete against your business.

Starting point is 00:02:38 And so you have a moat. It's just like you have your little castle and around it is a body of water that prevents the night from coming over. I want to give an example that maybe you haven't even heard of before. Around the year 1900, it was a great place to do business in Buffalo, New York. And there was a couple of reasons for that.

Starting point is 00:02:58 Buffalo, New York was able to have more reliable energy than almost anywhere in the world at that time because of the power plant with Niagara Falls. And then there was also access to the Great Lakes by extension in the Mississippi. So you could go out west. And then you could also through the Erie Canal, go to New York City and then the world. So if you were a business building in Buffalo, New York in around 1900, you had cost advantages both on the energy side and then also on the distribution side. If you were a business trying to compete in Pittsburgh, you didn't have those advantages. It would have been hard to compete against a business in Buffalo.

Starting point is 00:03:35 So that's one of those things that at that time would have made it very hard for any company to steal business from a company that was thriving in Buffalo. I feel like I was called off the bench here, like wrestling style to just be the heel or like, oh, we're talking MOTS, let's get Lou on. But yeah, I am a Mote's skeptic. And especially I love John's example there because the thing. is it didn't work out over time for Buffalo. And so that's the big thing. What we're talking about here is competitive advantages. And competitive advantages tend to not be all that permanent. When I,

Starting point is 00:04:10 I mean, moats, if nothing else, I think the concept is over you. I feel like it's like recession. For every 10 that are declared, maybe we'll have one. And I got to be honest, I don't think about moats in my investment process because I really believe that A, they're rare and B, they are almost impossible to identify in real time. Only in hindsight can we look back and say that was a moat. Look, BlackBerry had a moat. Kodak had a moat. Blockbuster had a moat. I know there's other examples, too, but if they had moats, then why is an investor, am I focused on moats, I guess? Well, yeah, to your point, too, Lou, you mentioned three things. We had Blackberry, Kodak, Blockbuster, all of which are others. Yeah. I mean, obviously others, and we'll get to some of them as well,

Starting point is 00:04:55 But it's the idea. And even to your point with Buffalo as well, John, the moats do change over time. This is not like some static thing that can be held forever because, you know, there are reasons. It's almost like it has to be cared for or nurtured or maintained in some sort of way to actually maintain its defensible. And sometimes it can't be maintained forever. You know, Buffalo got out produced by other places in terms of cost and production for various reasons over time. time. But, you know, if we think about what, John, what, when they work well, like, what are you looking for? Because, like you said, they're switching. Some of these things, they exist, but they sometimes aren't as powerful. So do you have an example of, like, when it works well, almost, like, an ideal situation? Well, I think that one moat that does work incredibly well is the moat that McDonald's has. I know this is a stock that we don't talk about very much, a business we don't talk about very much. And you may wonder what it kind of a moat does McDonald's has, isn't it just hamburgers? Yes and no, what many people don't realize, and there's a hidden

Starting point is 00:06:02 aspect here, so it's appropriate. We're talking about it on the Hidden Gems show. But McDonald's actually owns a very large percentage of the real estate, the McDonald's buildings that you see, the land that it sits on, McDonald's actually owns a very high percentage of that. Whereas operations, are done by independent third-party franchisees. Now, what this does for McDonald's, the parent company, is it really doesn't, it does matter, but not as much as it matters for other companies.

Starting point is 00:06:36 What is happening in the economy? So inflation can be eating into your cost. There could be pricing wars going on, maybe people not eating out as much, all sorts of things, changing consumer habits. But McDonald's is going to get its rental check every single month from its franchisees. That is a cost that is there. It can raise prices. The value of the real estate is inflation proof, and it's still, no matter what happens, that has value,

Starting point is 00:07:03 intrinsic value. So McDonald's actually generates the majority, the largest generator of revenue for the parent company is its real estate. If you are a business trying to compete with that empire, it's very hard. And to that point, many restaurant businesses out there don't own any real estate. And so when times get a little bit tough, they still have those rents to pay every single month and the profitability is what really gets hurt and squeezed and they get put in a tough spot. So McDonald's has a competitive advantage as far as I'm concerned. And just to be that guy, because again, I feel like I'm the foil here, I'd note that McDonald's has lost to the S&P 500 on a total return basis by 150 percentage points over the last decade. So again, as an investor,

Starting point is 00:07:48 I don't know if it's the first thing I'm looking at. That's not entirely fair. I know. But look, again, as far as what I do look at, a lot of it is regulatory related because laws are hard to change. The railroads are a great example. The railroads have some sort of a moat because ain't no way you're building new rail lines in the United States.

Starting point is 00:08:08 Situations like that where just it's impossible to get in, even if it makes economic sense, maybe that leans towards moats. But even then, I don't want to get too excited about it. We definitely got a little bit more of the cranky side on the Lou today because economic modes are important to some, not always to others. And to your point on regulatory sort of ones, that the ones that I tend to look for the most are that sort of ideal. Regional monopolies that are often dictated by regulations, landfills, rock quarries, things like that. Waste management and U.S. lime and minerals have been, in my opinion, some of the better examples of this because you can't build a whole lot of rock quarries, landfills anywhere else. And so the economic moat there is incredibly strong. Coming out after the

Starting point is 00:08:53 break, we're going to look at some of the misconceptions about moats and how investors can use them in the wrong way. John, I think it was interesting that you brought up the little book that built wealth at the top here. When Pat Dorsey wrote that book, he was the head of equity investment research at Morningstar. And they wrote a follow-up book a few years later. It's called Motes That Matter. It was written in a third. think about 2014. And it is a fascinating read because you go back and look at some of the things that they said at the time. And many of the companies that they said were wide moat businesses or, you know, companies that they really see a representative of a certain type of moat in a respective

Starting point is 00:09:40 industry. I was kind of looking through the returns of most of it. And it was really like a 50, 50 sort of shot of whether they got it right. I mean, the first one they go to is basic materials. And they said, new core and BASF, new core has been a great business. BASF, not so great over that time period. But I think it gets to that kind of point where moats and what you said, Lou, earlier, is that moats can sometimes be overinflated or misinterpreted, maybe not applied in the right way, or maybe we got it wrong in the first place. So when you think about applying, you know, economic modes to your business analysis,

Starting point is 00:10:16 John, how are you making sure you're not doing it wrong? Well, I think that Lou, cranky Lou, has already spoken to two of the misconceptions that I think people have about moats and that I do want to speak to. The first being that identifying a durable moat is the same as identifying a market beating investment. And that I do not believe is the case. I think some people do think it's the case. What it really does do is identify businesses that are probably still going to be in business in 10 to 20 years, but being in business is not the same as creating a lot of value for shareholders from now till then. So I think that is one misconception. Just because a business has a moat doesn't mean it's going to beat the market. Just because

Starting point is 00:11:01 a business doesn't have a moat, does not mean it will not outperform. I would say what was Apple's moat when it first went public compared to Microsoft, right? I mean, so a stock doesn't necessarily have to have a moat to create a lot of value. I would say the second. Second misconception, and this one is really important to me, it's why I'm really excited that we're talking about this today. MOTS are not static. And I think this is what Lou is talking to with, in regards to Buffalo. There was a time where it was great to do business in Buffalo, but that didn't always exist that way. It changed over time. In time, Buffalo was not the only city with good, reliable energy. More cities, that was a long-term trend that made it more

Starting point is 00:11:45 and more able to compete in other places. And so I always view personally, I view moats like this. I view all companies as either building a moat or their moat is eroding. I don't believe that any business is stuck in one place. I think even small companies, maybe it's only an inch wide, there is something that is allowing it to be in business today. And you can think of it as a moat in a way. maybe you can step over it with ease, but it's a little sliver in the ground, that is its moat. And the question is,

Starting point is 00:12:19 is it getting wider? If it's getting wider, that's actually a business that really interests me. I want to know how is it actually getting stronger? How is it actually able to, it's pushing its competitors further out by what it's doing today? So, and to the converse of that,

Starting point is 00:12:37 I think really wide moats can erode over time. And it can happen quite quickly in some cases. So is it getting wider? Is it eroding? I think those are the questions that investors should be asking, not does it have it or not have it binary question. It's a spectrum, wider or smaller? And again, to me, this just all comes down to it's a cute word for competitive advantage.

Starting point is 00:13:01 And almost every company, there aren't a lot of companies in a capitalist system that they're going to survive if they don't have some sort of competitive advantage. So, you know, you kind of back your way into either everybody has a moat and the moat doesn't matter or you can only see it in hindsight. And again, I just don't know how to use, oh, I see a moat here as an investment, especially as someone trying to look long term. I mean, look, unless I had a window into Apple's product development, I probably would have said that Blackberry had a moat before the iPhone. I probably, until Netflix announced their plans, would have thought Blockbuster has a moat. To me, the big takeaway is, is that, again, I don't see much value in trying. I mean, I look, yes, I want companies that have competitive advantages, but I don't find a lot of use, a signal, and not noise in just the whole moat discussion.

Starting point is 00:14:00 Yeah, and just to kind of wrap it up here on the misconceptions, as with anything, business analysis, valuation, you know, trend spotting, whatever tools you want to use, they are tools. We as investors, we have an investor toolbox and using the right one for the right situation is really what matters here.

Starting point is 00:14:23 There are actually plenty of, like, at least going back to that book, MOTS that Matter, there was like several industries where they're like, we just don't even see a moat. A couple examples they gave were like insurance companies and trucking and shipping businesses. But if you go down the list of companies in those respective industries,

Starting point is 00:14:39 you'll find a lot of marvelous businesses that have done incredibly well as publicly traded entities. And so when you're using these sort of tools, whether it be using economic moment analysis or SWAT analysis, strength, weakness, opportunities, threats, things like these, they help,

Starting point is 00:14:58 but you can't, they can't be all end all. And knowing which tools to use at any given point is really what matters the most. So we're going to take this concept to the economic moat and we're going to apply it to the real world here and try to give a couple examples of companies that we think right now are great moat businesses and maybe once it aren't quite doing what we thought so this is a stock investing podcast and we've talked a little bit about investing theory a little bit more in the first two segments here but one of the reasons

Starting point is 00:15:35 people want to go to these sort of podcasts is they want to hear the companies that are actually making this work so guys i'm going to put you on the spotlight here we're you think about economic moat as a way of analyzing a business, what to you is a company? And let's be even more specific since this is the Hidden Gems podcast. Companies in our Hidden Gems universe, in a recommendation service that we have at the Motley Fool right now, what is a company that you say has an excellent economic moat? One company that is really interesting to me in this discussion is Diendas Thresbe or BBB Foods. That is ticker symbol TBBBB.

Starting point is 00:16:13 This is a Mexican corner store, and it's really competing with a lot of mom and pop corner stores. What is interesting to me about TBB Foods, or excuse me, BBB Foods, is that over 60% of its sales are private label. So you start thinking through why does this business work? Shoppers are looking for cheap prices, and BBB Foods is able to sell a lot of private label brands at a cheaper price to get the sale, as opposed to name brand sales. The reason it can do this is because it has scale now, because of all the stores that it has and all the purchase volume it has, and it works directly with some suppliers to get good pricing. So it's kind of a economy of scale kind of a business. If you are a mom and pop corner store, you can't compete with that kind of a pricing.

Starting point is 00:17:09 And so it is, in some senses, a moat, particular with rivals that are smaller. Now, I will say when it comes to BBB Foods, I'm a little bit concerned with perhaps larger grocery competitors starting to move its direction because they will also command some of that pricing power. And it'll be interesting to watch what happens on price in that environment. But I would say, as of right now, BDB Foods has somewhat of a moat. I'd also put Mercado Libre in this camp, that's ticker symbol M-E-L-I. This is a company that has a marketplace, a fintech business, yes, but the real moat here is the logistics part of the business. It can deliver in its core markets in most of its stuff in two days or less. That is really hard for other companies to

Starting point is 00:17:58 compete. It's something that does attract shoppers. They know that they can get their stuff really fast. And that brings more shoppers to the marketplace, which attracts more sellers. Now it's starting to feed into somewhat of a network effect. And so I do think Mercado Libre as well is a widening moat business. So when I look, I still see durable competitive advantage in Visa and MasterCard. And I know that's kind of a weird thing to say today because the last, you know, decade or so, we've been hearing about how their moat, their advantage is going to disappear. But they remain the digital tow road for global commerce. I don't see that changing anytime soon. I don't see crypto doing that. But look, again, I guess it's a reminder that these things do

Starting point is 00:18:41 change over time because there are the constant threats. If the threats don't come, looks like a pretty good buying opportunity way they've been beaten down, I'd say. Similarly, if you look at an Apple or even a Microsoft, the painful switching costs of an operating system. the advantages of software developers all developing for your system and that critical mass, the Yogi Berra effect, that, you know, everybody goes there because everyone's there to kind of misquote Yogi Berra. But I do think these all have proven to be durable competitive advantages. I wouldn't go so far as to say any of them are permanent modes, as we've discussed, but I do think there's a lot of business, good businesses out there with competitive advantage.

Starting point is 00:19:26 Certainly it would take a lot more energy and inertia that we've seen so far from the crypto blockchain stable coin environment that was purported to disrupt the visas and the MasterCards before it actually happens. I mean, it could. It could. Well, and also, Visa and MasterCard can take a lot longer. Yeah, Visa and MasterCard can adapt those technologies and just bring their costs down too. Yeah. Well, I also want to kind of touch on like maybe ones that aren't quite on that economic mode analysis, what we were thinking. So again, sticking to the Hidden Gems universe, we make these decisions as a team here. And there's a couple where you guys are like the dissenting voice in the room.

Starting point is 00:20:06 So I'm going to give you guys the floor here. What is one of the companies in the hidden gems universe where, you know, maybe despite the consensus view that we have, you guys are kind of out of consensus. I'm worried about Airbnb. And this is the first time I've spoken publicly about this because I am, they say don't marry your stocks. I got married to Airbnb. I love this business.

Starting point is 00:20:28 I'm an early adopter. early investor. It's one of my favorite companies that said I am concerned about its moat. Airbnb's moat, yes, it does have a network effect, but in my view, that network effect stands on its real moat, which was an intangible asset, and that was the brand. It was the mind share that it occupied. I believe when Airbnb went public, something like 90% of the traffic to its platform was unaided. That means that somebody sat down, says, I want to travel, and they said,

Starting point is 00:21:07 I will go to Airbnb. They didn't need an ad, they didn't need a prompt, they didn't need anything. They were thinking, travel equals Airbnb. I think that that starts to become a little bit more disintermediated in what we're seeing with agentic commerce. If you are a serious vacation home owner,

Starting point is 00:21:28 you're listing on Airbnb. Absolutely. That's where the traffic comes from. But all the serious ones out there, most of the serious ones out there, have their own website. They would love to capture direct bookings if they could.

Starting point is 00:21:41 The issue is how do you drive traffic to your website? I think in the world of agentic commerce where someone is going to a, maybe it's an open AI, maybe it's a Claude, maybe it's something like that, or Gemini even,

Starting point is 00:21:55 and we're saying, here's where I'm traveling, I want this, I want that. and an agent is now booking, I can see a future where it's very easy for a website to integrate into that service, maybe with an API, and now we're bypassing the Airbnb platform altogether.

Starting point is 00:22:09 So I am worried in the world of Agentic Commerce, I'm worried about Airbnb's moat being able to survive. That is very, very timely, because even though we're recording this a week ahead of time, I think as this recording is dropping, we are actually doing a theme on Agentic AI in the time. travel as part of the Motley Fool as part of Foolfest coming up. So kind of an interesting, very serendipitous timing for this one, John. So here's one. I don't know if it's in our hidden

Starting point is 00:22:40 gems universe, but it's definitely in the Motley Fool universe. I've been told my entire investing career that Ther Isaac, kicker FICO has a moat because of that FICO score. I've been fighting this for a while. And now the stock is down 60% year to date because Fannie and Freddie are embracing vantage score or competitor. I think it has been sort of acknowledged. I'm not, you know, I think, I think at Motley Fool, we're kind of acting on this, so I don't want to say I'm a lone wolf here. But this is another one that it seemed like it, nothing could go wrong forever. And now it's, I think it's lost over 75% of its value just in the last few years. I think Fair Isaac is one of those examples. And similar to what we talked about with like Kodak and Blockbuster,

Starting point is 00:23:23 where it seemed like it was impossible to disrupt them because of reasons X, Y, Z, and the industry just kind of kept pushing along as it went. And then all of a sudden, something changed dramatically and all of a sudden that moat completely evaporated. So it'll be interesting to see whether or not though FICO is able to fend off the vantage scores of the world with innovation or whatever they can do

Starting point is 00:23:48 to try to fend off the competition you will with that economic mode. Well, that's all the time. we have today. This has been a little bit different. I hope everyone enjoyed it, and we'll see you guys next time. 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 ourselves stocks a silly way here. All personal finance content follows Motleyful editorial standards, and is not approved by advertising. Advertisements are sponsored content and provide for informational purposes only. To see our full advertising disclosure, please check out our show notes.

Starting point is 00:24:16 Thanks for our producer Dan Boyd and the rest of the Motleyfool team for John, and myself. Thanks for listening, and we'll chat again soon.

Motley Fool Money - The Might (and Myths) of Economic Moats

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