What a brazen supermarket can teach you about investing in great companies
Sooner or later, almost every hot product ends up in the middle aisle.
One of my favourite investment writers is Pat Dorsey. Which kind of makes sense because he put in place a lot of the equity research methodology we use here at Morningstar.
I recently read his Little Book That Builds Wealth on a weekend trip and especially liked the chapter on ‘Mistaken Moats’ – things that might trick you into thinking a company has a sustainable competitive advantage when it actually doesn’t.
As a quick reminder, we define a moat as a structural advantage that stops the competitive forces of capitalism from destroying a company’s ability to invest profitably in its business.
As shareholders, we want to benefit from our companies being able to generate profits and reinvest those profits back into the business at good rates of return. It is this reinvestment that can cause a company’s value to compound higher over time. Hence the attraction (some would say the necessity) of investing in companies with a moat protecting their business.
All else being equal, a company with a real moat protecting its business is more valuable than one without one. So if you invest in a business thinking it has a moat when it actually doesn’t, the price you pay can end up looking very expensive.
As a long-term shareholder in that company, you are also likely to suffer from the company’s profits and returns being whittled down by competition over time. In the book, Dorsey lists four classic sources of mistaken moat:
- Great products
- Great management
- Great size
- Great execution
Today I’m going to focus on the allure of great products. This isn’t because I want to annoy Peter Lynch, who famously recommended looking into the companies behind your favourite and most used products as potential investments.
Rather, it’s because Dorsey also compelled readers not to “fall in love with products” in his other (and in my opinion better) book, the Five Rules for Successful Stock investing. In other words, he thought it important enough to repeat.
Correlation and causation of moats
What do Apple, Nike, Coke and Microsoft all have in common? Probably a few things – but the main two I was looking for were that they all have Wide Moat ratings from Morningstar and they all sell great products that many of us use or consume several times per week.
Look down a list of Wide Moat companies, from AbbVie in drug manufacturing to Waste Management in – well, waste management - and you will find a whole host of companies that are great at delivering the product or service they specialise in. After all, it’s pretty hard to build a successful business if you don’t.
But are the products and services themselves the source or cause of the moat? No.
It isn’t just the Coke. It’s the brand they have invested in for over 100 years. It isn’t the drug itself. It’s the patents that stop other people from copying it and selling it. It isn’t the collection and disposal of garbage. It’s the fact that regulations and NIMBYism make their landfill network almost impossible to replicate.
The moat rarely comes from the product or service itself. It comes from whatever stops other people from copying the product or business model successfully. Which brings us to the Aldi principle.
The Aldi principle
Aldi is great. My partner and I do our big food shops there because the prices for groceries at Woolworths and Coles seem ridiculously high in comparison.
A highlight of any Aldi visit is the middle aisle. For the uninitiated, every week Aldi fill the middle part of their stores with a new roster of homeware, sporting goods, bits of outdoor furniture, you name it.
Quite often, these products will be own-brand dupes of successful branded products at much, much lower prices.
One time my partner loved the look of a $40 casserole pot, not knowing that I had already bought her the same one (only with Le Creuset written on the side) for her birthday three days later. That one stung a bit.
On my latest visit to Aldi, I grabbed a catalogue and saw the following product:
Ooni pizza ovens have been a huge hit in the UK. They have also been rather high up on my shortlist for a 30th birthday treat for some time. The reason I needed to save it for a special occasion is simple: they are expensive.
The model that appears to have been duped here retails in Australia for $699. But now you have Aldi selling a version for $199. And it can’t possibly be that much worse than the original. Can it?
Poor Ooni, I thought. Joining the likes of the Barney dog bed and Marks & Spencer’s Colin the Caterpillar chocolate cake from the UK – which Aldi sold as Cuthbert the Caterpillar – before them.
Sooner or later, almost every hot product ends up in the middle aisle.
Middle aisle resistance
This got me thinking about products that probably wouldn’t be a success in Aldi’s middle aisle. Even if Aldi sourced a really good dupe, and even if the product was being sold at almost a quarter of the branded product’s price like it is with the pizza oven.
If you can find a product like that, you might have found a company with some kind of moat.
My first thought was how unattractive Aldi (or Lidl, for that matter) might find it to make a dupe iPhone. First of all, think about how much it would cost to design and develop anything close to the software and features an iPhone has. A lot more, I imagine, than trying out a few pizza oven or pan manufacturers in China.
Even if you could build it cheaply, and even if you could run it on Android to give people access to loads of apps, would iPhone users want to leave the Apple ecosystem behind in favour of the cheap version?
Their iMessages, their iCloud storage, their Apple Pay, the painless syncing with their Apple Watch and AirPods would all disappear. Sure, a $100 iPhone dupe in the middle aisle might get some sales. But I don’t think it would put any kind of dent in the iPhone. Even if the product was – and this is very unlikely – just as good.
5 real moat sources
Even the iPhone - arguably one of the greatest products ever made - doesn’t command a moat all by itself. The moat comes from what’s stopping other people from selling the same thing, or from buying the same thing elsewhere.
So if a great product by itself isn’t enough for a moat, what is? At Morningstar, we think moats come in five different flavours:
- Intangible assets like brands, patents and regulatory monopolies
- Switching costs like the reasons you might not leave Apple's ecosystem
- Cost advantages, where a firm can still profit at prices that kill the competition
- Network effects, where the product gets more valuable as more users join
- Efficient scale, where it doesn't make financial sake for competitors to enter
To learn more about moats and how to find them in the wild, read my colleague Mark LaMonica’s article on how to find great companies to buy.
