The Quality of Competitive Advantages

By Paul Copeland, CFA

My father often told me it’s better to buy high-quality equipment and take good care of it than to just buy the cheapest option. I learned the hard way that he’s right, and I have a shed full of junk to prove it. Meanwhile, the John Deere tractor and everything else in his garage works perfectly—as it did when I was a kid.

At Trust Company of Vermont, we value high-quality investments. One criterion we use to evaluate company quality is “economic moat.” This is a term popularized by Warren Buffett for competitive advantages, which protect companies’ profitability—just as castles were built with moats to help protect against invaders. We look for companies that protect their profit margins for years to come. The length of time is especially important in taxable accounts, where gains can compound tax-deferred when they stay in the same stock.

While we diversify investments among many sectors to reduce overall account volatility, we see more wide-moat companies in some industries than in others. Later, I’ll explain what types of moats companies can build, but first it’s important to realize that the industry is often a factor on a company’s economic moat. In 1979, a now famous associate professor, Michael Porter, wrote an article in the Harvard Business Review titled, “How Competitive Forces Shape Strategy.” Porter’s Five Forces, introduced in that article, help me evaluate industry structures that lend toward higher profitability. The first four – buyers’ bargaining power, suppliers bargaining power, threat of new entrants, and threat of substitutes – lead to the fifth, which is of great importance: rivalry among existing firms. These forces help explain why we find more high-quality companies concentrated in some industries—and avoid others.

For example, there are no airlines on our approved list of The Quality of Competitive Advantages Paul Copeland, CFA & Portfolio Manager stocks. The airline industry is near the worst for profitability measured by return on invested capital. Through the lens of Porter’s Five Forces, we see that: 1) buyers can easily price shop airline tickets and most always do; 2) Airplane suppliers are a duopoly with just two firms, Boeing and Airbus, controlling the market; 3) While there are some significant barriers to entry (planes are very expensive and there are only so many gates at each airport), low-cost airlines can start with just a few routes (Breeze and Avelo are two recent examples); 4) Substitutes are available with automobiles, trains, and the recent widespread use of videoconferencing. These forces lead to rivalry among airlines so that even the best managed, like Southwest, have trouble consistently earning a decent return on capital. Other industries are on much softer ground in which a company can construct a moat.

There are reasons why you might not own a wide-moat company. Maybe it has a high valuation, doesn’t pay the dividend you want, or doesn’t line up with your personal values. Amazon is a stock that’s not for everyone, but it has been building a wide moat that should allow it to grow profits for many years to come. Here are the main building blocks of Amazon’s moat:

1. Intangible Assets: Amazon had over 2,200 patents granted in 2020, but I see its brand as a much more valuable intangible asset. Buying online requires trust. I’ve been burned online before, I don’t even compare prices like I used to. Although it’s easy to compare prices online, it’s often not worth the risk of a bad experience.

2. Cost Advantage: Amazon has efficient scale with technology, so it can sell at a lower price and still make more money than competitors. I made a mistake in a purchase the other day. What probably would have taken a phone call to a customer service agent and a bit of work and cost for another merchant was corrected with a few clicks of a button at Amazon.com.

3. Network Effect: More than half of the sales on Amazon are made by third parties. Merchants are attracted to sell on Amazon because of the many buyers. More sellers bring more products, which attracts more buyers. And more buyers attract even more sellers, etc. This network effect is so powerful that more product searches are now started on Amazon than even on Google. This strength shows in that Amazon had $31 billion in advertising sales for last year.

4. Switching Costs: I’m not a member of Amazon Prime (Amazon’s premium membership service, offering several services, such as free shipping, for an annual fee) but there are 200 million Prime customers who are incentivized to choose Amazon over other on-line merchants by the shipping benefits they get. The costs of switching are even more apparent in Amazon’s most profitable division, Amazon Web Services (AWS). Roughly a third of the activity on the internet takes place on AWS-hosted sites. If a company has its data on AWS, it’s more likely to use the AWS tools for analyzing and securing that data. Switching from a cloud provider can be a very difficult transition if a customer is relying on many of the AWS specific tools. The high-quality companies we often buy have established moats, so I spend less time looking for companies that might build a moat and more time analyzing whether a wide-moat company is maintaining its competitive advantage.

You might wonder if my holding period for Amazon stock is forever since I see a wide moat that should protect its long-term profitability. I would agree with its founder, Jeff Bezos, who said, “Amazon is not too big to fail…In fact, I predict one day Amazon will fail”. Moats in many medieval castles have dried up, and they wouldn’t protect inhabitants from even a small modern army these days. Likewise, many businesses lose their economic moats over time as high profits attract competition or the world changes. I saw this last year when our family visited the Strong’s Museum of Play in Rochester, NY, as part of a vacation to bicycle short parts of the Erie Canal Rail Trail. The museum is a creative gem that I most highly recommend to anyone, but Rochester was different than I expected. The city was home to Xerox and Eastman Kodak, imaging industry giants of the 20th century. Both had wide moats around their businesses that were decimated by changes in technology. Rochester was left with some magnificent buildings, but it has been struggling for over two decades to recover from the titanic commercial decline of those once thriving companies.
The high-quality companies we often buy have established moats, so I spend less time looking for companies that might build a moat and more time analyzing whether a wide-moat company is maintaining its competitive advantage. We often find that our investments have economic moats that are more stable than their daily stock prices, but over time stock prices follow higher profits allowed by wide moats, so we stay with the same investments for years.

At Trust Company of Vermont, we seek opportunities where we have a competitive advantage over other investors. Investing patiently in great businesses with strong economic moats is to our clients’ advantage. Most investors focus on short term price movements, the quarterly whisper numbers, breaking news, or quick-riches fads. Durable economic moats build wealth more slowly, so we have less competition as investors. A company might decide to sacrifice some profit this quarter to invest for future gains. People concerned mainly about the short-term will sell, which can create opportunities for us to buy into a business that will run (like my dad’s Deere) for many years to come.