As I started my investment journey in stocks earlier this year, all I could see were companies reporting revenue growths of more than 30% YoY. When I dug deep, I noticed that they have been growing at a fast clip for the last few years. FOMO crept in, and I immediately found myself buying the stocks of companies like:
- The Trade Desk (TTD)
- Shopify (SHOP)
- Fiverr (FVRR)
- ETSY (ETSY)
- Mercado Libre (MELI)
- CrowdStrike (CRWD)
- Twilio (TWLO)
- Zoom (ZM)
A big factor in choosing them was FinTwit. After reading glowing Twitter threads about the above companies, I was happy to have invested in companies that were in the hypergrowth stage. Over the next few months, I invested in them at better and better valuations.
All I could think was how these companies will continue to grow their revenues and thereby making me rich.
It was in the month of July when I started reading The Most Important Thing by Howard Marks. At first, I was reluctant to read someone who is a well-known “defensive” value investor.
Why would I want to play defensively when all I wanted was to grow at 30% CAGR??
But I pushed myself through the initial chapters. As I read, I realized:
- How important it is to stay alive in the investment game, and not chase fast growth all the time
- Being defensive is not about settling for average returns
- I need to build a strong conviction myself instead of relying on someone’s recommendation
I started becoming sceptical of my investments and wanted to dive deep into each of my holdings. The companies were definitely growing fast, but would they continue to grow like this in the future as well? I did read some deep dives before buying them, but I wanted to build my own conviction so that I can be confident in holding them through testing times.
But what framework did I believe in? My previous belief of investing in fast-growth companies – regardless of a moat – was beginning to crumble. I wanted to look at things beyond YoY revenue growth, margins, TAM and other numbers that can be fetched from any financial website.
Like any keen learner, I turned to the OG: Warren Buffett.
The most important thing [is] trying to find a business with a wide and long-lasting moat around it… protecting a terrific economic castle with an honest lord in charge of the castleWarren Buffett, Berkshire Hathaway annual shareholder meeting in 1995
Buffett made me take a hard look at the moats of each of my holdings.
What Is A Moat?
If you’re a fast-growing company with an innovative product, service, or process, you’re bound to attract competition. What else explains MySpace, Friendster, Hi5, Orkut, Facebook and Twitter in the 2000s when social media was just getting started?
Today, you may be the category leader growing at 30% YoY, but that doesn’t guarantee you will remain the leader in the space tomorrow as well. A more capable competitor can take away your throne if you don’t protect your business.
How do you protect your business from crumbling? Economic Moats. Wide Economic Moats.
Economic Moats was popularized by Warren Buffett since it forms a major criterion of his investment decisions. It refers to the ability of a company to withstand onslaughts from competitors, maintaining its competitive advantage over them – thus protecting its profits and market share.
Similar to how a moat protects a castle from invaders.
In addition to thwarting competition, wide moats also give companies pricing power. If a company can raise its prices without worrying much about losing customers, then it definitely has a wide moat because the competition can’t undercut it no matter how hard they try.
There are several ways a company can create a moat to protect its business:
- Network Effects: A product has a network effect when its usefulness increases as more and more people join the network. Example: Facebook. Facebook’s stickiness is high because everyone you know is on it.
- Cost Advantages: If you can provide the lowest cost among all your competitors, customers will always flock to you. It may be due to your scale or because of processes that your competitors can’t replicate. Example: Amazon. If a product can be bought online, there are high chances that Amazon has the lowest price.
- Switching Cost: A company has a switching cost advantage if it costs customers more to switch to their competitors. The cost could be in terms of money, time, or even risk. Example: Autodesk. Autodesk has been taught to architects & engineers for years and to switch to a rival product would cost them many many hours of learning, while dealing with the sunk cost of learning Autodesk.
- Intangibles: Intangibles like patents, trademarks, intellectual property, branding etc. can give a company pricing power. Example: Disney. It has an IP on a treasure chest of iconic characters that keep filling its coffers every year with movies, TV series, merchandise, etc.
Why Only Wide Moat Stocks?
Watching companies grow fast is great! As an investor, all you want is your money to compound as fast as possible.
But after I read Howard Marks, I realised that there’s one thing the majority of new retail investors tend to miss out on in a bull market: Risk Minimization. For me, minimizing risk is more important than looking for high growth stocks.
As an investor, you know that not every single holding of yours will give positive returns. That’s why we diversify, to mitigate that risk. I want to go one step ahead and have only a portfolio of wide-moat companies so that I can expect more of my holdings to give a positive return.
Long Growth Runway.
Wide moats help a company generate higher returns on the invested capital in a given year. This means, the company now has more capital to invest in the next year. The cycle continues and the company continues to grow for a longer period of time, decimating its competition.
If the management of a wide-moat company knows where and how to invest its capital (capital allocation skill) to get maximum returns, I would love to be its shareholder. Also, compounding works best only over the long term. A longer growth runway will ensure that my money continues to grow.
A high growth company without a moat will soon face increased competition, which will eventually eat into its profits over the long term.
What Do I Do With My No/Narrow Moat Growth Stocks?
I currently have 20 companies in my portfolio and I am going through them one-by-one assessing their moats. The pandemic has been a tailwind to these companies and they have grown faster than before. But I am looking at a 5-10 year horizon and asking myself if they have the moat to protect their growth.
For now, I have stopped adding to the ones where the moats were weak or non-existent. They are still growing, so I don’t wish to sell them for now. But their size in my portfolio will decrease over time as I add to my wide-moat holdings.