The Widest Moat In The World?

The peer review process has its detractors but overall the merits outweigh the disadvantages, otherwise sites like Seeking Alpha (SA) would serve little purpose. Even investment guru Bruce Berkowitz at Fairholme Fund hires an array of outside experts to poke holes in his analysis on specific stocks and bonds. Today I am challenging SA readers to define the company with the world's largest economic moat and submit their arguments to peer review.

For review, an economic moat is commonly defined as a competitive advantage that allows a company to earn outsized gains over time. Economic moats are usually identified under the following four subheadings (thank you MorningStar).

1) Economies of Scale -
2) High Consumer Switching Costs -
3) Intangible Assets such as
    a) Patent Protection -
    b) Government Permits -
    c) Brand Equity -
4) Network Effect -

Is your company's moat as wide as you think? Lets take a look at two companies widely regarded as having proven wide moats.

Phillip Morris International and Altria Group (PM and MO)

Marlboro is one of the most iconic and profitable brands in human history and the value of this brand has allowed Altria and Phillip Morris to earn high levels of return on investment for decades, but is this moat really as sustainable as we think? First, due to taxation and smoking bans Marlboro is facing increasing competition from counterfeits and generics. The comparative quality of generic brands across all consumer product categories has skyrocketed over the past ten years and consumers are catching on to the value that some discount brands are offering. Secondly, and far more importantly, Marlboro is losing its coolness factor. Today's young adult smoker prefers mentholated cigarettes to the traditional product. Newport (LO) and Camel (RAI) are eating Big MO's lunch when it comes to the menthol category, and this means when today's Marlboro smokers die they won't have a younger generation to replace them. Lastly, there is an undeniable prevailing demographic trend among consumers toward healthier choices, the end result of which is a progressively shrinking market for Phillip Morris to peddle its wares.

I think there's a bigger lesson to learn regarding the long term value of certain branded products. What's considered cool or popular almost never sustains the transition from one generation to the next. Even for commodities that are obviously cool like cigarettes and motorcycles, one brand rarely stays on top for long. When's the last time you had a Schlitz after work? Brand names may demand premium pricing but they don't infer continuing relevance and companies must continually invest in their brands in order to drive growth. As the quality gap between generic brands and premium brands continues to shrink, the value of a brand equity moat will continue to deteriorate. I personally find it difficult to believe that many brands like Nestle or Altria will be able to achieve the "aspirational brand" status that allows companies like Burberry (BRBY) and Coach (COH) to sustain premium pricing.

Johnson and Johnson (JNJ)

Even before the seemingly never ending product recalls, consumers were already starting to figure out that the store brand cold medicine has the exact same chemical compound and list of active ingredients as the major brands, and at a lower price. Prevailing issues with the consumer products portfolio aside, the strength of JNJ has always been the patent protection of their medical devices and pharmaceuticals. Nothing can assail the competitive advantage of a patent, right? While I still believe that JNJ has a dominant moat, I think the value of patents in the health care industry are undergoing a sea change. Efforts by cash-strapped European and American governments to control health-care spending will result in the following...

1) higher costs associated with proving the safety of new treatments will result in additional costs for patents pending, as the government moves to reduce its reliability for malpractice.
2) the length of time in which new drugs are protected under patent will be put under constant pressure by government subsidized health care programs needing to reduce costs in order to stay solvent.

Therefore the return on investment for companies in the health care sector will shrink as they cope with higher development costs and greater generic competition. This scenario has already been realized in the European anti-bacteria drug market (in the interest of public health, of course), and it stands to reason that it will slowly breech other market segments as well. Large cap pharmaceuticals companies will most likely see slower growth and reduced margins for their products over time. The moat around JNJ isn't going to disappear anytime soon, but the value of that moat is under pressure.

So what are the widest moats in the world?

While earnings will fluctuate over time due to a variety of reasons, a company's assets are more durable and easier to put a fixed value on. When a railroad lays down a peace of track there is little incentive for a competitor to lay track next to it. However, the railroad must still compete with shipping, trucking and air freight companies to deliver the goods at the most competitive price. Oil and natural gas pipelines enjoy the same advantages that railroads do from owning nontransferable physical assets, but without as much competition from alternative shipping options. In fact, when a company like Enterprise Products (EPD) agrees to build a pipeline or storage facility, they often have a long term contract in place that guarantees the company a profitable return on investment before they even start building the project. Furthermore, these companies are insulated from commodity price volatility because they are paid for volume shipped and not for the spot price of the product delivered. This makes the midstream MLP space one of the widest moat industries in the world. 

However, even these strong competitive advantages are not unassailable. As the world's energy demand ramps up and individuals and governments start to take notice of the environmental cost associated with meeting that demand, there is going to be a continued emphasis on moving away from traditional energy sources like coal, oil, and natural gas toward renewable sources like wind, solar, geothermal, hydroelectric and nuclear energy. That means lower volumes for pipeline companies as the industries they service slowly but surely become technologically obsolete. Admittedly this won't happen any time soon, but even a wide moat industry like midstream infrastructure faces competitive and demographic pressures.

So where am I casting my vote for world's widest moat company? Basic Sanitation Company of the State of Sao Paulo (SBS).  The company is a public water and sewage services provider to approximately 20 million people in Sao Paulo, Brasil. The company also designs and builds water treatment facilities and distribution networks. SBS is a publicly traded monopoly. The company's assets closely resemble those of Enterprise Products. They own water and sewage pipelines that deliver essential commodity services to homes and business, and the rate of return is calculated and known prior to the building of any new projects. The key advantage for sanitary water is that unlike oil and gas, potable water faces no foreseeable threat from new technologies, therefore the pipes that SBS own have a longer life span in which to earn consistent, stable and high rates of return.

No company is perfect and SBS faces regulatory issues that may or may not force the company to make capital expenditures at unfavorable rates of return at the whim of government meddling. Furthermore, the company is heavily dependent on weather conditions as a large part of their water supply is captured rain fall. Even taking that into consideration, I  think that the company's many competitive advantages bestow a wide economic moat that will allow the company to earn outsized returns over a significantly long term investment horizon.

An investment in any individual security assumes that the investor believes the company possesses some advantage that gives it an edge against its competition. Even an investment in a broad market index assumes that the investor sees a risk-reward advantage in not trying to outguess the market. By challenging ourselves to define the company with the largest economic moat we force ourselves to think critically about what characteristics comprise economic advantages and which advantages are the most valuable.


Disclosure: I am long EPD, PM, MO.