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Digging Moats

A very popular investment question about a business is – how big is the moat? The size of an advantage from competitors is important. A moat is a good measuring stick for medieval castles and of stocks for the future. As a portfolio manager, the problem can be that large moats are often clear for many to see, which can erode a company’s advantage and our research edge.

I prefer to ask what is the direction of an advantage?

The data for those answers may be tiny changes but offer profound clues about which companies may quietly be digging deeper or wider moats. Crowds of investors around established moats often overlook subtle improvements elsewhere and price them both accordingly.

We hold Stock Tournaments on Saturdays when the markets are closed, so we can re-score all stocks when they are not moving. We will share the most recent example below.

There is a guy I want you to meet first. He owns one of those humbly improving businesses, in between Houston and Austin, often overlooked on the way to see bigger things. I predict you will be unable to hear the word moat ever again, and not think of Mike Newman.

Mike opened a bakery thirty-seven years ago in Bellville, Texas, where he was born and raised. He has small profit margins in a tiny town of about 4,000 people. For both reasons, he has never attracted competition. Anybody who tried, he outlasted with better recipes and warm service. Nobody there has a better breakfast, and nobody has another bakery at all. I have been a customer for years when I get out of Houston, which is home to over 12,000 different restaurants.

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Mike gets teased about the old-fashioned décor with no updates out front. He still has a wall of mugs by the coffee station for all his friends in town, who are there every day. He just loves baking his favorite recipes over and over, for a room full of customers he loves serving. On a typical day, neighbors sit alongside a motorcycle gang, next to a ladies group flipping cards, and across from the “Romeos” (retired old men eating out sometimes).

Nothing ever changed for the customers who loved what they ate at Newman’s. But, the business was becoming more profitable. Houston more than doubled in size just since I have been going to Newman’s. Not only are there far more weekend trips made through Bellville, but now weekend homes are built near it. I have a few clients that do not even call it a trip to Bellville anymore, but rather a daily commute to Houston, after moving there.

Mike kept adding delicious choices behind the bakery glass (that he never changed out). He added a short-order kitchen, and a lunch menu. Newman’s now has more than 100 delicious items to choose from that he kept making better, for happy (and more net-new) customers. In hindsight, I should have known how buttery the bakery’s margins were expanding, never adding any extra footprint or big expenses at all. Wait till you see how I finally found out….I was too busy eating to see this moat being dug around Mike Newman’s castle.

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Curiosity > Conviction

We try to make sure we do not drive past subtle improvements in the Stock Market. Our Stock Tournaments make stocks compete against each other, using our recipes of numbers. This is pure math, no opinions. There is no room for predictions about what should be happening, only a deeper dive into what is happening that we might be missing. The reason we do it this way is to make sure we are not focusing only on business we know or like, but to find businesses we need to learn. At the same time, since competition is the key ingredient in capitalism, this must include our own holdings and making certain we eliminate the weakest company from our portfolio’s roster, when better potential is identified.

Part of the reason I’ve been a little more successful than most people

is that I’m good at destroying my own best-loved ideas.” -Charlie Munger

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In this Stock Tournament for potential “Moat Stretchers,” we are not looking through the most popular quantitative filters. We are neither looking for high growth rates, nor cheap prices. For starters, we make it exceedingly easy to qualify as you will see in the top blue bar. We have only asked here which companies have…at least $1 in operating profit last year along with sales and cash from operations not declining over the previous 5-years. So, ANY tiny $1 and 1% increases at all, are all it took. Those three minimum requirements eliminate 207 of the S&P 500.

There is no perfect way to measure moats. Competitive advantages in most businesses can be found in their pricing power with customers, and how profitable is their operation. Those next three green bars above offer only a few ways to compare businesses. Rather than looking for large margins, we made stocks compete for ANY positive change in their directions. After those three rounds, another 162 stocks are now eliminated and we are down to 131 advancing to the final round.

Capitalism will find the biggest margins faster than ever before. So, I am more interested to find any sized advantage that might be increasing for some reason maybe not yet apparent to investors crowded around larger moats. Every one of our Stock Tournaments have one thing in common – we are always curious and never convinced.

“If we knew what we were doing, it wouldn’t be called research, would it?” -Albert Einstein

The biggest companies in the world are no different than that little bakery when their menus and customer bases change. The Stock Tournaments are our way of asking a few questions of the cashiers for all the companies using their reported numbers.

((As a related side note, our data source bracketologist is Ycharts. They attacked Bloomberg’s giant moat successfully and won my company over as a client, after many years running my tournaments on Bloomberg. We enjoy Ycharts cleaner design. And, a big difference was good ole fashioned warm personal service which is a unique ingredient in the quantitative world.))

The final round of this Stock Tournament is Research & Development, which is hardest to quantify. For one thing, there are a few errors of omission. We do not have the R&D expense line for a few companies. It is worth looking at this data that most companies show clearly, and is one of our favorite factors to get a peek around the corner for potential. We find it’s one of the least measured by investors looking for more fast growth now, instead of wondering what might make new growth down the road.

“Luck is the residue of design.” -Branch Rickey

Only 30 of the S&P 500 stocks advanced through that last round of any increase in the growth rate of R&D spending. The chances are pretty good that inside this small group of companies there will be an unusual amount of changes for us to study.

The Stock Tournaments are just the beginning of our work to identify which companies we might not know enough about. Then the homework begins, taking a deep dive into each company, one at a time. Many companies we will never understand clearly enough to consider owning. We just wanted to share part 1 of the process, to illustrate how even the smallest changes in direction of any advantages can quickly separate companies.

Over time, studying the potential of Moat Stretchers has led us to some of our biggest winners. We use strict sell disciplines for all the times we are wrong. That peace of mind allows us to spend more time learning new stuff, rather than doubling-down to review or try to justify losers.

Smaller companies offer even more opportunities to find early moat excavations, and of course more risk that they never get established. Using the exact same qualifying rounds of the Stock Tournament above to carve up the S&P 400 and 600 (mid & small cap indexes), oddly enough results in the same number of companies that advanced through each round: only 30. Looking at these potential “SMID” (small+mid) Moat Stretchers over a tough period for smaller companies is a good reminder that expanding margins may offer a little extra cushion during tough times. Or, may point to businesses that might be expanding an advantage, regardless of the overall economy.

“Bad companies are destroyed by crisis, good companies survive them,

great companies are improved by them.” -Andy Grov

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A Peek Around The Corner From The Bakery

Mike Newman is my favorite reminder that looking at the size of an advantage (early batches of his cookies were pretty good, but cmon…) is less important than paying close attention to the direction of that advantage over time (products and customers multiplied, while costs did not). I missed it. I drove right past the best illustration of what stretching a moat can result in – anywhere. Only four miles away, hidden in the trees way off the road I drove down many times, I had no idea Newman’s expanding margins were enough to build an actual moat…and a castle.

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As I walked through, I couldn’t stop shaking my head and Mike couldn’t stop smiling. I asked how long have I been driving by the most unusual home I’ve ever seen?! He modestly confessed, “Well it took me a lot longer than I thought.”

He has his own chapel underneath a 62-foot bell tower. He built a great dining hall looking out to a huge courtyard. Mike says he liked the defenses of the Middle Age castles the most, so naturally he brought in 16-foot logs for a rock catapult.

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All the contractors he interviewed for the big job thought Mike was crazy. “I came up with the designs from my imagination. I’m a baker.”

So, he learned on the job how to do it all by himself. I am standing in my favorite R&D project of all-time.

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After rising at 3 a.m. for the bakery, he left after lunch and started building this castle block by block, by hand. “Those were some long days,” Newman smiled again.

He had only one assistant and it took over eight years to build it all. But here is my favorite part, Newman winks “I’m still adding on, it’s a work in progress. I will never finish.”

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As we walked across his 3,000-pound drawbridge, Newman explained how it is manually operated since he wanted an authentic one. He giggled, “You just can’t buy a drawbridge at Lowe’s or Home Depot anymore.”

Now you know a couple of the images that pop into my mind on deep dives of research, constantly wondering what I have underestimated, completely missed, or who just might be building something none of us has ever seen before.

“What is now proved, was once only imagined.” -William Blake

Mike says about his castle with a moat around it, “It’s perfect, a medieval home for a man in a medieval trade.” Sometimes, it is the smallest improvements in an overlooked business that produces the biggest rewards.


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