Three Book Recommendations on Moats
I recently did two interviews (I’ll link them below). Both times, I was asked for my favourite book recommendations. During the last couple of years, I became very interested in moats, or competitive advantages, so I answered with three books I enjoyed on this topic.
Instead of doing book reviews, I thought I’d highlight a few of my favourite quotes to give you a flavour of each book and maybe entice you to pick one!
The Little Book That Builds Wealth - Pat Dorsey
It’s easy to get caught up in fat profit margins and fast growth, but the duration of those fat profits is what really matters. Moats give us a framework for separating the here-today-and-gone-tomorrow stocks from the companies with real sticking power.
Although there are times when smart strategies can create a competitive advantage in a tough industry (think Dell or Southwest Airlines), the cold, hard fact is that some businesses are structurally just better positioned than others.
In my experience, the most common “mistaken moats” are great products, strong market share, great execution, and great management. These four traps can lure you into thinking that a company has a moat when the odds are good that it actually doesn’t.
The four sources of structural competitive advantage are intangible assets, customer switching costs, the network effect, and cost advantages. If you can find a company with solid returns on capital and one of these characteristics, you’ve likely found a company with a moat.
A brand creates an economic moat only if it increases the consumer’s willingness to pay or increases customer captivity. After all, brands cost money to build and sustain, and if that investment doesn’t generate a return via some pricing power or repeat business, then it’s not creating a competitive advantage.
The only time patents constitute a truly sustainable competitive advantage is when the firm has a demonstrated track record of innovation that you’re confident can continue, as well as a wide variety of patented products.
Companies whose futures hinge on a single patented product often promise future returns that sound too good to be true—and oftentimes, that’s exactly what they are.
You’ll notice I haven’t mentioned many consumer-oriented firms, such as retailers, restaurants, packaged-goods companies, and the like. That’s because low switching costs are the main weakness of these kinds of companies. You can walk from one clothing store to another, or choose a different brand of toothpaste at the grocery store, with almost no effort whatsoever. That makes it very hard for retailers and restaurants to create moats around their businesses.
Switching costs come in many flavors—tight integration with a customer’s business, monetary costs, and retraining costs, to name just a few.
Cost advantages can stem from four sources: cheaper processes, better locations, unique assets, and greater scale.
A final type of scale advantage is domination of a niche market. Even if a company is not big in an absolute sense, being relatively larger than the competition in a specific market segment can confer huge advantages. In fact, companies can build near-monopolies in markets that are only large enough to support one company profitably, because it makes no economic sense for a new entrant to spend the capital necessary to enter the market.
Companies that provide services to businesses are in many ways the polar opposite of the restaurants and retailers. This sector has one of the highest percentages of wide-moat companies in Morningstar’s coverage universe, and that’s largely because these firms are often able to integrate themselves so tightly into their clients’ business processes that they create very high switching costs, giving them pricing power and excellent returns on capital.
Bet on the horse, not the jockey. Management matters, but far less than moats.
7 Powers: The Foundations of Business Strategy - Hamilton Helmer
Scale Economies: A business in which per unit cost declines as production volume increases.
Network Economies occur when the value of a product to a customer is increased by the use of the product by others.
Counter-Positioning: A newcomer adopts a new, superior business model which the incumbent does not mimic due to anticipated damage to their existing business.
Switching Costs arise when a consumer values compatibility across multiple purchases from a specific firm over time. These can include repeat purchases of the same product or purchases of complementary goods.
Branding is an asset that communicates information and evokes positive emotions in the customer, leading to an increased willingness to pay for the product.
Cornered Resource: Preferential access at attractive terms to a coveted asset that can independently enhance value.
Process Power: Embedded company organization and activity sets which enable lower costs and/or superior product, and which can be matched only by an extended commitment.
Power comes on the heels of invention, be it in products, processes, brands or business models. However, most invention is merely a manifestation of operational excellence and thus not immune to the arbitraging actions of competition.
Good managers can rarely reverse the course of a bad business, i.e. one without Power. Over and over, I have witnessed Buffett’s axiom play out in the press, with business leaders castigated for poor management ability in the face of seemingly impossible circumstances. Yahoo, Twitter and Zynga come to mind here. That said, when it comes to establishing Power in the first place, make no mistake: leadership is fundamental.
Quality Investing: Owning The Best Companies For The Long Term - Lawrence Cunningham, Torkell Eide & Patrick Hargreaves
In our view, three characteristics indicate quality. These are strong, predictable cash generation; sustainably high returns on capital; and attractive growth opportunities. Each of these financial traits is attractive in its own right, but combined, they are particularly powerful, enabling a virtuous circle of cash generation, which can be reinvested at high rates of return, begetting more cash, which can be reinvested again.
One way of assessing the durability of a competitive advantage is to invert the analysis. Instead of looking at what supports a competitive advantage, we analyze what it would take for a newcomer to replicate the business and remove the advantage. Such analysis often reveals idiosyncrasies that can be instructive in assessing a business's quality.
Sustained high gross profit margins relative to industry peers tends to indicate durable competitive advantage. Zeroing in on gross margins, as opposed to bottom line net income, also helps distinguish competitive advantage from managerial ability: bloated but short-term cost structures can reduce net income and disguise real long-term competitive advantages. High gross margins also confer other advantages: they can expand the scope for operating leverage, provide a buffer against rising raw material prices and provide the flexibility to drive growth through R&D or advertising and promotion.
When the argument for holding a position starts with a "yes, but", it often means both that a mistake has been identified and that someone is unwilling to admit that. If a company has highlighted a problem, the market knows about it; and its price-earnings multiple will have accordingly contracted (‘’the stock is cheap now’’). Many investment mistakes of retention follow such special pleading: if a position is maintained as a result of "yes, buts" it is probably a mistake.
For many fallen angels, overall deterioration generally begins with small things not going according to plan: growth not materializing, unexplained pressure on margins, more discussion of competitive pressures, or gradual increases in capital expenditure. Each disappointment is small in isolation; management provides a good explanation for each and dismisses them as non-recurring. But a string of setbacks often signals a larger set of problems, which emerge or crystallize after it is too late for the business to make corrections or for the investor to mitigate losses. Thus even small setbacks warrant rigorous evaluation.
A business that is solely linked to customers' capital expenditure makes for a much more complicated investment than one linked to their operating costs. In most cyclical industries, capital equipment is purchased amid periods of capacity expansion. On the other hand, for a company whose profits tie to customers' operating costs, cyclicality poses less risk of disruption and remains relatively predictable.
Recent Interviews
In case you missed it, Robin Speziale interviewed me on the Capital Compounders Show in December. The episode is available on YouTube (below) or all major podcast platforms.
I also did an interview with Redeye, a Swedish investment bank, that was published in writing last week:
Microcap Talks: #1 Exploring Canada with Mathieu Martin
We chat about my unusual background, investment strategy and some of my 2025 top picks.
That’s all I have for you today!
I’m leaving for Mexico on vacation tomorrow. It will be good to disconnect for a week. I hope to be able to do some reading and thinking, which will be no easy feat with two young kids!
My Good, Bad, and Ugly - January edition should be out upon my return late next week.
See you on the other side ✌️
Disclaimer
This publication is for informational purposes only. Nothing produced under the Stocks & Stones brand should be construed as investment advice or recommendations. Mathieu Martin, the author, is employed as a Portfolio Manager with Rivemont Investments. This publication only represents Mathieu Martin’s own opinions and not those of Rivemont. Rivemont may own positions and transact on any securities mentioned in this publication at any time without prior notice. At the time of this writing, the Rivemont MicroCap Fund does not hold positions in any of the companies mentioned. Always do your own research and consult a professional before making investment decisions.
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