Welcome to the introduction to Rule #1 course, I’m Phil Town and this is Tutorial 3: Moat (Part 1)- A Durable Advantage.
This is part 3 of a 9-part series on How to Invest using Rule #1 strategies
Part 1: Rule #1 Strategy- Overview of the Basics
Part 2: Meaning- The Three Circles
Part 3 [You are Here]: Moat- A Durable Advantage
Part 4: Moat- The Big Four
Part 5: Management- Owner Oriented
Part 6: Margin of Safety- The Growth Rate
Part 7: Margin of Safety- Sticker Price and MOS
Part 8: Margin of Safety- Payback Time
Part 9: Zombie Value- Tangible Book Value
Moat: What is it in Investing Terms?
A moat is obviously the water around a castle but in investing terms, a moat is the durable competitive advantage that a company has that protects it from being attacked by competitors.
A moat is what makes a company predictable and allows us to put a value on the business. Charlie Munger said that “Coca-Cola is the perfect business because it has this gigantic durable competitive advantage, or moat, which gives it predictable cash flow.” This allows us to figure out what the future cash flow will be and value the company today, so we know whether we can buy it on sale or not.
5 Kinds of Moats
There are five kinds of moats: brand, secret, toll or toll bridge, switching, and price.
1) Brand Moat
An example of a brand moat is Harley-Davidson. A brand moat is a lifestyle moat. Lifestyle is a huge area for brand building and Harley is brilliant at it. They build a lifestyle around the Harley-Davidson culture.
2) Secrets Moat
The second of the five moats is a secrets moat. 3M is brilliant at creating products around adhesives that they then patent and turn into products. They’re a gigantic secrets company.
Another secrets company is Pfizer. They make Lipitor and a lot of other drugs that they patent and have exclusive rights to for many years.
A company like Dow Chemical, which creates a lot of products using their technology and secrets in the lab, that they then also patent. A secrets company is a big moat company.
3) Toll Bridge Moat
The next type of moat is a toll bridge moat. A great example of that is Pacific Gas and Electric. If you want to get power in California, then you pretty much have to go through PG&E.
Another toll bridge moat is the Chicago Mercantile Exchange. They’re the only place in America where you can trade commodities. Burlington Northern Santa Fe Railroad is another example of this type of moat because pretty much all the railroads in America have some sort of a monopoly.
4) Switching Moat
The next moat is a switching moat. Switching is the cost of shifting from one supplier or product to another. Costs like redoing all of your software for example, that links your entire network together. Which is why it’s tough for companies to shift off of Microsoft, into say something like Apple.
Another company that has a nice switching moat is Intel. Once a company like Apple has built their computers on an Intel chip, it’s really hard for them to shift to some other competitor.
Another example is ADP Payroll Services. Once they get in your back office and start doing your payroll, they’re there forever. The cost to switch services is just too much.
5) Price Moat
The fifth moat is the price moat. Walmart of course is the king of price moats. That is a company that can create products, or sells products much, much lower than anybody else.
Costco also competes on that basis, as does JetBlue, for example.
You might notice that a lot of these companies have multiple moats. Certainly, you can have multiple moats, the more the better. But every good company has at least one of these kinds of moats: brand, secret, toll bridge, switching, or price.
Make sure that with any company that you are looking at buying, you can identify the moat. Your job is to look in industries you understand and find big moat companies.
Your homework for this tutorial is to take the company that you found in the last tutorial, and figure out what moat that company has. Is it a brand moat, secret, toll bridge, switching or price moat? Now, go on to Tutorial 4: Moat (Part 2)- The Big Four Numbers.