• Chris Mayer

Invisible Moats

The most basic recipe for a 100-bagger calls for a business with a high return on capital. Then you mix in a lot of years. Put that combination in an old coffee can, store in a cool dry place and check on it occasionally. The longer you let it go, the bigger the multi-bagger.

Of course, finding a business that generates a high return on capital and can reinvest and keep doing it year after year is not so easy. There are always competitors. Peeps don’t tend to sit around watching other people make a lot of money. They want a piece of the action. Hence Coke has Pepsi, McDonald’s has Burger King, and the Yankees have the Boston Red Sox. (Okay, maybe that last is a bad example).

How does a company keep competitors at bay, so it can enjoy the blissful road to 100-baggerdom? This brings us to the idea of “moats.” Or, as Thomas Phelps, author of the first book on 100-baggers called them, “gates.” I included a chapter on moats in my book 100 Baggers.

An economic moat refers, in the words of Morningstar, “to how likely a company is to keep competitors at bay for an extended period.” A successful moat allows those high returns on capital to persist.

Usual moats include things such as the “network effect” “low cost advantage” “switching costs” and “mafia connections” (I kid!). If you want to a quick refresher on moats, I refer you to Morningstar’s discussion here:

One of the fun things about investing is figuring out the moat and debating it with your friends. Moats are not always so easy to identify or agree on.

I have a friend who runs another fund and we like to go back and forth debating moats on names we own or are looking at. We often agree, but pushback is encouraged. We recently disagreed over a couple of names and the discussion might be interesting to you.

Old Dominion Freight Lines

Old Dominion Freight Lines (ODFL) is… well, out of laziness, let me just quote Morningstar again:

“Old Dominion Freight Line is the third-largest less-than-truckload carrier in the United States, with more than 235 service centers and 9,200-plus tractors. OD is by far one of the most disciplined and efficient providers in the trucking industry, and its profitability and capital returns stand head and shoulders above its peers. Strategic initiatives revolve around increasing network density through market share gains and maintaining industry-leading levels of service through consistent infrastructure investment.”

ODFL has been a wonderful compounder. As pointed out in its 2019 report, shareholders have enjoyed annual returns (including dividends) of 30.7%, 19.8%, and 30.2% for the previous three-year, five-year, and ten-year periods, respectively. And this year, the stock is up another 30%.

Return on invested capital (ROIC) has improved from single digits a decade ago to more than 20% today. The company operates in a market with a lot of competitors, but has continually taken market share. It’s now #2, behind only Fedex Freight. (It was number 3 recently, behind XPO, but has overtaken it). Last year, ODFL won the Mastio Quality Award as the #1 National Carrier for tenth straight year.

Yet, my friend is put off by the competition. What is it that ODFL does that another trucker can’t do? There are still lots of competitors. He sees no moat. And just to show he's not crazy, Morningstar agrees. They give the company a “no moat” rating. Here is a snippet from Matthew Young’s report on ODFL:

“In our view, even the best operators (like Old Dominion) struggle to carve out a sustainable competitive edge via the key economic moat sources: cost advantage, intangible assets, switching costs, and network effect.

"At first glance, it might appear that the high-fixed-cost nature of LTL operations should allow for enduring scale-based cost advantages, or perhaps benefits from superior internal processes that optimize line-haul and pickup and delivery efficiency. However, routines capable of maximizing productivity can be replicated by well-capitalized competitors over time, and scale economies have largely proved insufficient across the industry. The near bankruptcy of industry behemoth YRC Worldwide following the 2009 freight recession stands as a prime example."

They give ODFL one measly star, the lowest possible rating, and put fair value at $80, half of its current stock price.

I beg to differ. To me, a company with rising ROICs and rising market share must have something that others find difficult to replicate. I think Young’s YRC analog is not a good one because YRC is unionized. That’s a big disadvantage. Over time, non-union shops have steadily gained share at the expense of unionized competitors. And YRC’s finances seem perpetually in bad shape with a lot of debt and pension obligations. ODFL has a strong balance sheet with little debt and is nonunion.

But I admit ODFL doesn’t seem to have a traditional moat that fits in one of those buckets. Instead is seems to have pieces of the different buckets. Somehow the whole adds up to a strong competitor versus just looking at the parts.

I would point to their physical network. As ODFL says in a presentation: “Since the beginning of 2010, we have invested $1.5 billion in service center additions and expansions - adding 27 service centers (a 13% increase) and increasing our door count by approximately 51%.”

This is not easy to replicate and run as efficiently as ODFL does, even if you had $1.5 billion lying around and locations as good as ODFL's. Plus, there is a subtlety in the trucking business. ODFL is a less-than-truckload (LTL) carrier. This means it takes smaller shipments and consolidates them on one truck. The service centers do the loading/unloading in an efficient way. Here is Return on Capital -- a service I recommend --- on how it is not so easy to compete with ODFL:

“If you wanted to start a truckload business, it’s pretty simple. Given that contracts are awarded on a “full truckload” basis, there are little economies of scale and profitability is very binary (getting a contract gives you a certain margin and not getting the contract leaves you unprofitable), you don’t need more than one truck to start the business. The main start-up costs are (1) a truck and a trailer, (2) obtaining insurance and licenses to operate as a truckload business and (3) hiring a driver. The big issues truckload carriers face are (1) there is high driver turnover because the job is physically tolling (some drivers must take a load across the country in a few days with little rest whereas LTL carriers complete many smaller trips) and (2) the relative value vs. rail isn’t that much higher while rail is cheaper (railway companies actually get economies of scale, allowing them to charge more competitive prices).

"LTL is a different story. Here, the barriers to entry are much higher – to achieve profitability, you must win many contracts to fill your trucks up to the brim. More importantly, you must have consolidation centers to load/unload tonnage mid-route based on location/size. For this reason, the industry is highly consolidated: the top 10 LTL carriers control ~55% of the market.” [Bold added].

I agree with this. There is also an ownership culture here that is hard to copy. Scuttleblurb -- another service I recommend -- wrote up ODFL in 2017 and made an interesting point on the culture:

“The Congdon family has continuously run the company since ODFL’s founding in 1934, retaining Board and management presence and a 13% stake in ODFL shares [John Congdon (Chairman; 4.3%); Earl Congdon (Executive Chairman; 2.7%), David Congdon (CEO; 5.8%)]... Two salesmen I spoke with a few years back had their entire 401(k)’s in Old Dominion stock and conveyed that Old Dominion stock is widely held among rank-and-file employees. ODFL shares comprise over 20% of employees’ 401(k) assets. A significant portion of service center managers’ quarterly bonuses are directly tied to profitability and service levels. Old Dominion’s employee turnover, at 10%, is the lowest I’ve come across in the industry and the labor force, unlike those of most LTL peers, is union free.”

Is that not a moat of a sort? Maybe I’ll call it an “invisible moat.” An invisible moat is one that doesn’t seem to fit any of the traditional buckets, but one that leaves a trail of rising ROICs and increasing market share.

Note, I don’t own ODFL. I have a hard time justifying the price today. But I like it. And I think the business will continue to compound over the next decade at a healthy clip.

What do you think?

Debating Moats Again

My friend owns a small software company. I won’t name it because he’s still buying. But this is a case where we were on opposite sides again. This software company has 1% market share in a sea of competitors. Worse, many of these competitors, some with much bigger shares, give their product away -- using the “freemium” model or ad-based model. My friend's software company charges for their product.

I argue no moat. Too many competitors doing the same thing, it seems to me. And this company is tiny. But my friend argued that the company earns stupid high returns on capital year after year and enjoys high renewal rates on its software. Kind of as I argued with ODFL, he made the case that there is clearly something here. Perhaps it too has an “invisible moat.”

I dunno. It’s fun to debate the point. And these are the differences that make a market. We will see. In any event, thinking about moats is important if you want to play the buy and hold game. (If you want to trade tanker stocks, who cares).

The basic point of the exercise is think deeply about what makes a company special and why its success should endure. Work done here will lead to owning more sleep-well-at-night investments, perhaps especially important in the crazy virus infected markets of today.

Thanks for reading.


Published June 23, 2020

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