This quote is from a speech I gave in 2011 to a collection of healthcare analysts who were grappling with understanding a company’s moat and its importance in a company’s valuation. Re-reading it eleven years later, I’m not sure I’d change a single word. The only addition I might make is to be “very” conservative in your estimates (not just conservative) when valuing a possible investment’s moat.
Generally, when we get moats wrong at Nintai, it’s because of two things. The first is that business conditions change enough to impair the company’s ability to maintain the characteristics of a wide-moat business. Secondly, as investors, we convince ourselves the company has achieved a wide moat when one has never existed. In the final analysis, the damage is the same in both, though it generally goes much quicker in the latter than in the former.
I’m going to discuss both cases in much greater detail. Both can be deadly when it comes to long-term performance. I recently wrote an article about New Oriental Education and Technology (EDU), a holding in some Nintai investment partner portfolios that lost 75% of its value in two days in 2021. That poor choice was a combination of Option # 1 (the company lost its ability to maintain a moat due to changes in governmental policy) and Option #2 (the moat we thought the company had was much weaker in reality).
In today’s article, I wanted to discuss Option #1 (why a company's moat might fail) in much greater detail. Before I get started, it might be helpful to quickly review what Nintai thinks are the primary sources for sustainable moats.
A Brief Review of Moat Characteristics
A competitive moat is a term first used by Warren Buffett to describe a company's competitive advantage over time. This competitive advantage creates an “organizational moat” that makes it more difficult for competitors to capture market share, increase prices, or build a better mousetrap. The broader and deeper the moat, the better the protection and the greater the likelihood the moat is sustainable over the long term. No company has better articulated Buffett’s concept of moats than Morningstar. Their “Economic Moat Ratings” are essential in understanding how a company derives its moat, sources, durability, and trend. The company’s “Why Moats Matter: The Morningstar Approach to Investing” by Heather Brilliant and Elizabeth Collins remains a true classic.
Morningstar’s Types of Moats: We agree with Morningstar that there are certain forms of moats. These include Network Effect (whereas more users join a network, the more powerful it becomes as dictated by Metcalfe’s Law), Intangible Assets (where patents, brands, or regulatory approvals can create legally-derived moats around a business), Cost Advantage (where a company can keep costs down, but profits up regularly), Switching Costs (where it becomes cost and skills prohibitive to remove a product from the customer’s business processes), and Efficient Scale (where several players dominate a market that lends itself as too expensive to build out a competitive offering – like pipelines). We use some specific measures at Nintai that we think are critical components to any company with a moat.
High Returns on Invested Capital: Companies with wide moats can use capital to produce high returns on said capital. In plain English, this means a company can utilize capital (such as cash, debt, or money raised through stock sales) by deploying it into either existing operations (such as building a new plant) or new operations (such as an acquisition or creating a new product) that generates high returns on the invested capital. Great companies find ways to use the money to increase their moat, while poor companies generate inadequate capital returns by squandering it on bad business deals or product development.
High Free Cash Flow Conversion: At Nintai, we look for companies that convert 25% or greater revenue into free cash flow for at least the past ten years. After paying all the bills to keep the business running (labor, SG&A, leases, capital expenditures, etc.), the company clears over one-quarter of all revenue as wholly theirs. This demonstrates that the company can achieve extremely high profitability and has enough cash to little to no need to go to the capital markets or raise debt.
Competitive Strength: We also look for companies with obvious competitive strengths. Easily identified strengths are monopoly or duopoly (when there are only one or two companies in that line of business, an investor should expect to see higher growth rates and increased profitability. Another example is dominance achieved through regulatory or patent protection. When a pharmaceutical receives a patent for a particular molecule or product, this guarantees exclusivity for anywhere between 7 - 15 years. Not bad if you’re the only company treating a specific disease.
Excellent Capital Allocators as Managers: Just because a company can achieve high returns on invested capital and find ample opportunity to invest in the current business doesn’t mean they will. An equally important component has a management team with the discipline to stay with projects that aim for high returns on invested capital, as well as the discipline to reject those that don’t have those characteristics.
Why Moats Fail or Get Filled In
Of course, nothing is better for an investor than bringing a company into the portfolio and watching it broaden its moat, grow revenue, increase profitability, and successfully allocate capital to grow the company over a ten to twenty-year period. At Nintai, we’ve been lucky to have a couple of these, including Manhattan Research (MANH), Intuitive Surgical (IRSG), and FactSet Research (FDS). Unfortunately, we’ve also had more than our share of portfolio holdings where the moat disappeared, along with our investment case and investment returns. Several great (perhaps that’s not the word) examples from Nintai’s past include Corporate Executive Board (merged) and New Oriental Education (EDU), and Computer Programs and Systems (CPSI).
Each of the latter cases involved companies that faced a rapid decline or collapse in their competitive moat. This further led to a near-complete collapse in stock price and competitive position. In each of these cases, one of three reasons led to such rapid changes.
Government Regulations Change: The old phrase goes that the good Lord giveth, and the good Lord taketh away. Indeed, nothing could be more accurate than the case of New Oriental Education and Technology. For nearly two decades, the ruling Chinese Communist Party (CCP) encouraged families to invest in learning English as a second language, getting tutoring services to improve those skills, and leveraging EDU’s country-wide infrastructure to increase their skill sets. In 2021, the CCP pulled the rug out from tutoring companies complaining they were forcing families to spend too much on education as a percent of their total family income. In one week, the government completely obliterated the business and investment case in the mainland China for-profit education market.
New Technology/Product/Process is Developed: Sometimes, it’s as simple as competitors exploding on the scene with a new product or offering that instantly makes a business or product obsolete. For instance, in most major cities, there are a limited number of hackney medallions that allow you to drive a taxi. In Boston, there are 1,825. At its height, cabs picked up 14.6M fares in 2012. That number dropped to 5.9M in 2018. In 2021 it was estimated to be roughly 2.3M. The cost of a medallion has fallen from $900,000 in 2013 to $34,000 in 2021. The reason for this collapse? The democratization of ride-sharing through Uber and Lyft. In the blink of an eye, the entire business model of the taxicab in major cities was blown apart.
Management Takes Their Eye Off the Ball: Occasionally, great companies will have management takeover that aren’t as good capital allocators as their predecessors. A former holding in the Nintai Charitable Trust portfolio - Computer Programs and Systems (CPSI) - saw return on equity drop from 43.3 in 2014 to -11.6 in 2017 under new management. This type of collapse in return on equity reflected a broader breakdown in the company’s moat, leading to the permanent impairment of Nintai’s capital. In this instance, management took its eye off the ball of the electronic health/medical record (EHR/EMR) space and lost its competitive advantage over the next few years. The stock price shared an equally severe drop, and Nintai’s investment was permanently impaired.
Signs of a Deteriorating Moat
What should an investor look for when identifying if a portfolio holding’s moat is deteriorating in size or scope? Here are some things we look for at Nintai Investments.
Revenue Decrease: a slight and consistent decrease in revenue tells you more about an eroding moat than one awful year. When a company sees revenue decrease year-over-year for an extended time, it can mean the company’s product is losing the loyalty of customers, loss of pricing power, or that the company simply isn’t executing its strategy very well. Whatever the reason, decreasing revenue is not what an investor is looking for in a company with a narrow or wide competitive moat.
Profit Decrease: Another sign of a deteriorating moat is squeezed gross and net margins, or most importantly, a decrease in free cash flow or free cash flow as a percent of revenue. Any of these three might suggest the company no longer can keep costs contained (raw supplies costs have increased or the labor market is too tight) or worse; it is losing the battle of maintaining control over pricing versus customers who don’t see the value anymore.
Decreasing Market Share: A clear sign of an eroding moat is when a portfolio holding sees a marked deterioration in market share. Numbers like this reflect something either very wrong at the portfolio company or something very right at a competitor. As an investor, we prefer to see it the former, not the latter. Why? Because this is something in the company’s control that with the right management team, strategy, operational team, and adequate capital, can be solved. That said, any solution must thread the needle of all these listed issues as well as complete them in a reasonable period. Many customers won’t have the patience to see a vendor go through a series of missteps.
Specific Government Action: In some instances, a government may change its policies and have an enormous impact on a company’s moat. For instance. Mexico’s government provides supportive policy to three Mexican publicly traded airport operators – Grupo Aeroportuario del Pacifico (PAC) holds the most significant passenger market share at 26%, compared with 23% for Grupo Aeroportuario del Sureste (ASR) and 15% for Grupo Aeroportuario del Centro Norte (OMAB). Any change in government policy - such as moving to a more free-market model or a change in licensing – could dramatically impact each of these companies’ competitive moats.
A Note on Speed
Some of the previously mentioned events can lead to much quicker moat deterioration than others. For instance, a change in government policy - created by a change in administration or simply an unplanned policy change - can destroy a moat in days. For example, Nintai’s investment in New Oriental Educational (EDU) lost its entire moat and most of its valuation in just 72 hours in the summer of 2021. Others, such as decreasing market share, can take years of erosion to eat away at a company’s moat. In Computer Programs and Systems case, it took several years before the extent of damage to the company’s moat was identified.
Questions to Ask Going Forward
Inevitably, an investor will own a portfolio holding that shows the signs of a weakening moat, as described in the previous section. When this happens, there are several questions the investor should ask relative to the future of the moat, can/will it return, or is there an opportunity to create an entirely new moat.
Is the Moat Permanently Impaired?: The first question an investor should ask is whether the moat has been permanently impaired. Events such as the loss of a patent, a radical change in government policy, or the launch of a truly ground-breaking new product by a competitor can usually mean the damage can be ascertained quickly. But most cases aren’t so clear-cut. Sometimes it can take several quarters or even years before the erosion, and its certainty becomes clear. We’ve found the best way to mitigate the risks associated with this long-drawn-out process is to know your portfolio holding, market, and competitors exceptionally well. If the investor isn’t willing to do some real, in-depth leg work, then find a quality index fund.
Can the Company Rebuild the Moat?: This is one of the more difficult questions an investor will have to answer about moats. The company and its team have already built a moat, so we have a cognitive bias in our thinking that says they should be able to do it again. But you have to let all that information go and dwell on the facts of why and how they lost the moat. It would seem unlikely they can rebuild the exact same moat because that one blew up. So, what would need to change? Strategically? Operationally? Does the company have a management team capable of identifying the required changes? Does the company have the capital required to make the changes? Again, an investor needs an in-depth knowledge of what made up the previous moat, what a new one might look like, and all the necessary information on competitors, markets, strategy, operations, financials, etc.
Can the Company Build a Different Moat?: This question can usually be answered the quickest of the post-impaired questions. We have found over time that it is challenging to not only rebuild a competitive advantage but to build a moat in an entirely different field. You certainly want to believe in management. After all, they’ve shown remarkable skill and drive in creating a solid business already. Who says they can’t do it again? But building a moat in an entirely new field or industry is another whole ball of wax. Having confidence in your management to rebuild an existing moat is one thing, having it in them to build a moat in an entirely new industry or vertical? That’s more likely to be a pipe dream.
Building a business surrounded by a deep competitive moat is quite a task. Identifying a market, creating a product, fending off competitors, and achieving long-term growth are all marks of a great management team. Inevitably, the hallmarks of such success tend to get weathered and fade away. For a host of reasons (listed previously), a portfolio company’s moat can (or will) deteriorate with time. The challenge for the investor is to purchase shares when the moat is in the ascendancy and not overpay in those circumstances. The second key is recognizing when a moat is weakening, identifying the causes, and ascertaining whether management can turn the situation around. A wise investor can sometimes avoid conditions that lead to crack-ups in a business’s competitive moat. But we all make mistakes. This article can’t guarantee you won’t make such a mistake in the future. But it hopefully outlines some of the issues an investor can keep in their desk drawer and pull out now and then to refresh their memory.
As always, I look forward to your thoughts and comments.
DISCLOSURE: Nintai currently owns New Oriental Education and Technology (EDU) and Manhattan Associates (MANH) in both client and my personal investment account.
 These examples are components of Morningstar’s “Economic Moat Rating” and “Moat Sources”. More information can be found here.