Recently I’ve read an article by Todd Wenning, CFA (@ToddWenning) from Intrinsic Investing: “The Evolution of Moat Analysis”. The article is very interesting and talks about a central topic in investing, Moats. The first time I read the article I realised that the author was explaining something interesting, but from my point of view and without knowing why, some pieces didn’t exactly fit in the puzzle of ideas that he presents. My comments may sound pretentious since Todd is saying something pretty similar, but I found it enriching to share my reflection.
“Economic Moat sources – low-cost production, network effects, switching costs, and intangible assets – may remain constant, but ultimately what determines a moat is how those sources build entry or scaling barriers for competitors. Once a barrier to entry is lowered, what matters is how quickly the entrants can scale.”
First of all, there are some moat sources that are scale-dependent, as cost advantages moats (niche market, manufacturing or distribution) or the network effect, I think this moats are very difficult to be lowered. In the past, Brand sourced moats where powerful, because the building of a brand needed a huge investment in marketing and advertising, now the barrier has been lowered, so apart from building a meaningful brand you have to look for other moats. Scaling in production or distribution or taking a niche market is the next step after you have created a recognized brand. So until here I agree with Todd, I understand that when he talks about lowered barriers of entry thinks about non scale-dependent moats.
“With traditional tangible asset-based moats, barriers to entry are typically high (need for capital, expensive factories, etc.), but economies of scale are more achievable as expansion allows the spread of high fixed costs over a broader base.“
Here I find the first discordance point with Todd, if you look industry by industry you will find that gross margins are bigger in the software industry where production didn’t have an important physical limit to overcome and sales can grow without affecting to much the original structure.
“The opposite is true with intangible asset-based moats. It’s easier to enter a market but much harder to scale in capital-light businesses. You could start a new social media company in your garage on a shoestring budget, but you’re up against significant network effects and switching cost advantages held by the incumbents. Further, it’s not always apparent which capital-light company is prudently scaling because they are expensing reinvestment, often resulting in near term, low reported profit margins.”
So, I think that looking to the spreadability of fixed costs, which happens in both tangible and intangible asset-based industries, isn’t the main thing to discuss. From my point of view, the ability to scale in capital-light business is not much harder than in tangible-asset ones, in fact I think is easier because, ¡is cheaper! Taking in account the importance of the network effect moats in this type of business (software, e.g.) where scalability is less costly that in those with big fixed assets we arrive top the next situation. The market leaders in asset-light industries can reach a massive scale (remember no-physic limits) which makes the ‘minimum economically viable scale’ higher and more difficult to reach, but scalability is not harder. Remember that nowadays big players in asset-light sectors, with big network effects are lowering prices and creating big entry barriers. As it looks to me, everything is related with operational leverage (roughly spreading fixed cost over a broader base) and could be stated as follows. The bigger the operational leverage level in a industry, the bigger you have to be to reach a minimum economically viable scale, or with a lower barrier of entry the importance of scale in moat creation grows in a inversely proportional way.