The importance of moats for dividends

When looking at dividends and the sustainability of those dividends, I always look to the characteristics of the underlying business that I am invested in to determine the durability of the dividends and the likely level of dividend increases. The existence of moats play a big role in that process.

 

What are moats?

I believe it may have been Warren Buffet that first came up with the concept of moats to apply to investing. Its a term that you hear in business strategy discussions often. At its most basic, the idea of a moat refers to the advantages that a business possesses to help keep out invaders from overrunning their “fortress” so to speak.

In other words, its the set of tools and competitive advantages that a business possesses to repel competitors from completely commoditizing their business, damaging revenue growth, margins and profitability.

Moats are hugely important for dividend growth. A company with no moat or a sub par moat will soon find their business overrun with competitors, if they are experiencing significant revenue growth. Success always attracts competition.

Prices will get pushed down, the business will experience revenue declines and profit issues. If its lucky and the market the business is in is growing strongly, it may continue to retain its share of the growth. If its unlucky it goes under.

Retaining a moat over a long period of time is pretty tough, but as a dividend growth investor, I think you need to be invested in companies that will have a moat for years. Ultimately, the way you drive lasting dividend increases is through increases in top line revenue, which you ultimately manage into sustained increases in profit and cash flow.

There’s no other way to generate strongly increasing dividends otherwise. Sure you can squeeze out expenses, you can boost the amount of retained profits that are paid out of the business. But there are only so many expenses you can squeeze before you damage the company brand and unique value proposition.

Paying out too much in retained profits as dividends brings the risk of underinvestment in the business. You don’t innovate. Your value proposition becomes stale. Somebody else outflanks you.

Companies that have proven their ability to retain their moats over many years are the best candidates to consider for dividends. They’ve proved they have a value prop  that they can defend and which is enduring. That’s not to say that moats last forever.

So what makes a solid wide moat?

Intellectual Property

The best moat in my opinion is one that is protected by law. You have some unique patented formula, some secret sauce that you can own, patent and then makes billions from.

Coca Cola has a unique patent around its formulation for Coke. Apparently its so well guarded that its tucked away in a secret safe somewhere with heavy security. It better be. It accounts for a significant portion of the value of a $180B business.

Big pharma were at one time the most effective users of patents. Of course, they only have patent exclusivity for 7 years after which point generics are able to come in and overrun their businesses. They have struggled for many years to since come up with new products. Hence the big pharma moat is not as wide as Coca Cola in my view, as they have a more limited form of IP protection.

Qualcomm – This is probably one of the least well known examples of strong IP commercialization. But they’ve made a mint for the patents they hold for CDMA radio technology, which is the basis of the architecture operated by folks like Verizon Wireless.

With the sole patents on CDMA radio technology, they were making an absolute mint from wireless carriers licensing that technology. Its a bit hard to negotiate pricing with someone when they are the only game in town.

Regulation

Regulated moats are also somewhat protected by law. Certain companies have the benefit of regulation which confers a barrier to entry to a competitor entering a market.

Banks are a good example. Not anyone can just up and decide they are going to become a bank. You need a certain capitalization, you need to be regulated by the FDIC, you need to show ongoing compliance with a variety of regulations.

Provision of utility type services also requires being approved and regulated by certain bodies and being compliant with a variety of standards.

Telecommunications providers like Verizon for instance need to be regulated by the FCC, and operators of power and gas plants also have certain conditions that they need to comply with in order to maintain their permits to operate these plants.

While regulated utilities tend to be cash generating machines, they can have fairly low rates of revenue growth. Providers of gas and electricity services negotiate with state agencies for rate increases that they in turn are allowed to charge customers.

Of course while these can occasionally be generous, being dependent on state agencies for returns typically translates into limited scope for revenue increases, which in turn can translate to pretty limited dividend growth.

Switching costs

Switching costs refer to the ease of customers being able to easily move a service from one provider to another.

From a consumer point of view, you can see some limited switching costs in moving from one bank to another. The hassle of going down to a branch to close an account or switch your mortgage can make consumer banking a fairly sticky service. People are generally loathed to go through the hassle of making such a switch.

Similarly, Apple has done a pretty good job of building in switching costs into the Apple ecosystem. By have proprietary formats for music, video etc, it becomes difficult for someone to up and leave to another platform without having to go through a massive effort of converting their content library into another format.

You tend to find much stronger examples of switching costs in the enterprise. Its not easy for an Enterprise customer to migrate over from an Oracle ERP system to SAP without a lot of effort and integration planning.

Similarly, payroll providers like ADP and Paychex have a very strong lock on companies with their payroll processing systems. The amount of effort to move over to a different payroll system is non trivial.

Marketing  & Distribution

A number of companies have perfected a tight package of distribution and operational efficiency to complement a core product or IP. Its hard to have a sustained competitive advantage with just marketing and distribution alone without a killer product, but having a competency here can give you an enduring moat.

Coca Cola, Pepsi and even McDonald’s have perfected a great product with distribution and operational efficiencies. They are able to move cans of coke or set up the production of french fries in many places  around the globe, delivered in a standardized manner with consistent quality.

That you can have a set of McDonald’s fries taste the same in any restaurant around the globe considerably enhances McDonald’s brand capital and the likelihood of repeat visits from consumers.

Fastenal, which manufacturers and distributes fasteners used in manufacturing can claim a moat based on its ability to distribute any fastener to any location within the fastest amount of time.

Location

In certain industries, location can lend itself to the existence of an economic moat. Companies such as Burlington Northern and CSX have economic moats by virtue of where the railroad assets are located.

Having rail tracks in high trafficked corridors, or those with strong economic activity creates a moat because that the existence of that infrastructure makes it less likely that another competitor can come along and replicate that access given geography and other logistical barriers, such as negotiating new access permissions across territories and setting up similar infrastructure.

Finally location can be a huge strategic advantages for mineral  and aggregates producers. Having a quarry located close to a port can make a huge difference in terms of the viability of development, particularly if a quarry isn’t located close to the point of the end customer.

Of course, being located close to a customer site can lead to a significant competitive advantage and economic moat, and other competitors may not be able to claim an equivalent advantage. Vulcan materials economic moat stems from the fact that it is located so close to many of its customers and its not economically viable to transport aggregates more than 50 miles.

The widest moats

The widest moats come from a combination of multiple individual moats. Consider the case of McDonald’s, which has multiple economic moats in my view. McDonald’s have considerable IP around the production of a variety of food products at low cost. Further, they are able to distribute and standardize the production of those products across a number of store formats and countries.

Finally McDonald’s stores have the advantage of being located in high trafficked areas which are heavily frequented. All of these things put together provide McDonald’s with a wide economic moat, and provide McDonald’s with considerable brand equity, which it can use to roll out new products and new format stores (ie McCafe).

Using Financials to confirm the existence of a moat

In my view you can quickly confirm the existence of a moat by looking at a companies financials. I’ll be following up this post with a subsequent one that looks at a companies financials  to provide evidence of a moat, or alternatively evidence of whether  a moat has been breached.

 

Comments

  1. Your article has got me thinking about my positions. I never bothered looking at the moats of companies I hold; stock price and good to excellent management were my priorities. Since protecting dividend growth is of concern to me, I’ll be looking into moats. Thanks for the informative post.

    • Integrator says:

      Thanks for the feedback average div yield. Ill be following up this post with one later in the week that looks at more of a quant analysis to unearth the existence of an economic moat, so stay tuned! Hopefully that provides some signs of things to look for in the numbers as to where an economic moat may exist.

  2. FI, I really liked this article. Looking for stable dividend producing investments that have the ability to withstand outside forces speaks of one of the fundamental principles that dividend investors like us need to understand and employ well. The concept of a “moat” is great for illustrating this concept in a universal way. I am looking forward to seeing your followup article – keep up the good work!

    Michael

    • Integrator says:

      Thanks MIchael. While the is never anything guaranteed with an investment, a moat helps provide me confidence that a business can withstand most things that the external environment may throw at a company.

  3. Great post with really solid companies as examples. I appreciate the specifics about what makes up a moat and many different ways a company can thwart off the competition.

    • Integrator says:

      Thanks DL. There are probably even other moats beyond the categories that I’ve outlined, but these were the most obvious one that came to mind.

  4. Martin says:

    I agree on importance to review the company moat. Although I invest in companies with narrow moat, I like companies with a wide moat a lot. The greatest example was a few years ago JNJ. It has so wide moat that when those idiots out there were trashing the stock because of some recalls and they were predicting the end of JNJ I was laughing and buying everything I could and had money for. So, when you ever see a behemoth with wide moat being on a sale because of someone thinks it’s the end of the world, buy everything you can.

    • Integrator says:

      Martin- fully agree. If you can buy a wide moat company at a fair price, I think you will benefit handsomely over the long run. Buying such a company at a discount makes it highly probable that you will be very happy with your purchase decision in years to come.

  5. Great article. I’m looking forward to your follow up article on how to identify a wide moat using te company’s finacials. I mostly use morningstar to see if a company has a wide moat, but I also look at return on equity and return on invested capital compared to industry averages.

    I recently wrote an article that identified US Dividend Champions, Challengers and Contenders that have a wide moat rating from Morningstar. Here’s the link:http://www.dividendgrowthinvestingandretirement.com/2013/07/wide-moat-stocks-in-the-us-dividend-champions-list/. Let me know what you think.

    Cheers.

    • Integrator says:

      Thanks DGIR. I think you can infer much about a companies moat from a long term trend (10 yrs +) in revenue, gross margin, operating margins and return on equity. Positive trends in these measures suggest the existence of a moat to me.

  6. Steven of Chicago says:

    Nice article. Railroads and public utilities also provide a wide moat.

    • Integrator says:

      Agree Steven. In my view railroads have a moat by virtue of the access rights they have negotiated, while utilities tend to have a regulatory moat going for them.

Trackbacks

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