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Moats: Profit Fortifiers

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Life in medieval times was hard. Notwithstanding the occasional case of Black Death, constant risk of starvation, and relative shortage of hot showers, lawlessness abounded. Finding shelter -- safety from hostile elements -- wasn't an easy feat. The only surefire defense was a moat, quite literally. While the modern world has afforded certain comforts, business is every bit as cutthroat. Profitability, for businesses, is constantly under assault. As in the medieval fiefdom, their only defense is a moat.

We recently attended the 15th Annual CFA Equity Research and Valuation Conference, and among the topics discussed, the idea of moats -- what makes them, keeping them, and how they contribute to companies' undervaluation -- was a topic of avid discussion. Two points, in particular, caught us.

Of moats and undervaluation
Morningstar's Grady Burkett and Rick Summer described the essence of business quite succinctly: "Capitalism works. High profits attract competition." That's what makes a moat important. It protects a company's ability to earn fatter and more consistent profit margins for a long time.

That moats make good business is not a new or unique insight. The challenge is discovering a company that consistently earns well, and whose ability to do so is not fully appreciated by the markets. Those are the ones that -- absent business-specific stressors, a market that hits the reset button, or economic concerns -- given a long enough time horizon, can be had cheap. The trouble is very practical. As a general matter, the market understands and appreciates excellent businesses, and for the most part, it values them appropriately (or at a premium) relative to their potential.

The most fertile hunting grounds, in my opinion, are in emerging moats -- those that are subtle, but profound and ever-increasing. Because they aren't immediately obvious, companies can build substantial beachheads. In the earlier innings, and sometimes even later, the market doesn't appreciate the ability of companies to earn fat profits for a long time.

Of the possible nascent, misunderstood, or underestimated competitive advantages, one stuck out: What Burkett and Morningstar call "efficient scale." Here, a company, or companies, addresses a niche market quite effectively. Would-be competitors shy away because it's too small, or too small relative to the cost of building a presence. The incumbents earn fat profits as a result. Examples include chip-tester KLA-Tencor (NASDAQ: KLAC  ) and aircraft parts supplier Rockwell Collins.

Now for an industry that's building efficient scale and isn't appreciated by the market: containerboard makers. Ongoing industry consolidation, relatively high costs of building new mills, and waning growth prospects have endowed industry participants with renewed pricing power. Industry biggies International Paper (NYSE: IP  ) and Rock-Tenn (NYSE: RKT  ) are primed to reap the rewards.

Moat shrinkage
The makers of Zubaz pants thought they had built a brand that would resonate with puffy-pants and zebra-print enthusiasts for decades. Somehow (I still can't imagine why), the strength of the Zubaz brand weakened and the company's ability to charge a premium price faded. Even more durable moats have expiration dates: Tastes change, patents expire, and technology disrupts. Dell (UNKNOWN: DELL.DL  ) is a great example: The company's manufacturing prowess gave it advantage over its competitors for years, but there was little stopping firms from copying its ways.

Burkett and Summer (as well as NYU professor Aswath Damodaran) highlighted the importance of assessing the length of time a moat will persist -- also known as the competitive advantage period. The longer a company's competitive advantage period, the longer it will be able to earn economic profits, and the more valuable its business. Burkett and Summer believe that Facebook (NASDAQ: FB  ) has an incredible, although still evolving, economic moat in advertising, payments, and more, which will afford it the ability to earn great profits for decades. Damodaran, on the other hand, sees competition encroaching on Facebook's turf in about 10 years. Both expect rapid growth and high profitability, but the result of Damodaran's shorter assumed competitive advantage period is that his best guess at what the company is worth is $7 lower than what Burkett and Summer think it is worth, and is the difference between Burkett and Summer thinking Facebook is undervalued and Damodaran believing it is overvalued.

The Foolish bottom line
The point is simple: Moats matter, in business, investing in businesses, and determining when to double down -- or cut your losses. Investors ignore them at their peril.

More expert advice from The Motley Fool
After the world's most hyped IPO turned out to be a dunce, most investors probably don't even want to think about shares of Facebook. But there are things every investor needs to know about this company. We've outlined them in our newest premium research report. There's a lot more to Facebook than meets the eye, so read up on whether there is anything to "like" about it today, and we'll tell you whether we think Facebook deserves a place in your portfolio. Access your report by clicking here.

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