Why You Want the Companies You Own to Have Big Moats

In this podcast, Motley Fool senior analyst Asit Sharma discusses:

• Meta Platforms (META -1.12%) bouncing back from its recent lows.
• PayPal's (PYPL -0.27%) strong first-quarter revenue and lowered guidance for the full fiscal year.
• The growing strength of ServiceNow's (NOW -1.12%) cloud business.

Motley Fool senior analyst Jason Moser and Motley Fool contributor Matt Frankel discuss some ways to identify businesses with moats and share some stocks that know how to protect themselves.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on April 28, 2022.

Chris Hill: [MUSIC] We like big moats and we cannot lie. Investors can't deny. I'm not singing the rest of this, we got too much to get to on this episode. Motley Fool Money starts now. I'm Chris Hill, joining me is Motley Fool Senior Analyst, Asit Sharma. Thanks for being here.

Asit Sharma: Chris, thank you for having me.

Chris Hill: Jason Moser and Matt Frankel are going to be here later in the show to talk about moats, also known as one of the biggest advantages that business can have. But we're going to check in on the latest from PayPal and ServiceNow, let's start with Meta Platforms. Shares hit a 52-week low on Wednesday. Today, shares are up more than 10 percent off of that low because of a first-quarter report that wasn't perfect, but it definitely had bright spots. Meta Platforms seeing a rise in both active daily users and revenue per user. What stood out to you?

Asit Sharma: Chris, for me, I think what stood out was made for TV Disney movie element in this earnings report. By that, I mean, in some Disney movies of old, you had the crazy tinker as genius farther who would spend part of the family's budget on stuff for his creations. Then at some point, the mom would step in and say, hey, we've got to send the kids to camp this summer. You can't keep pouring money into this, we've got to make it through the month. I think this was Meta Platforms realizing that as much as they want to invest in the metaverse, they can't go all-in. They dialed back their projected expenses for this year and this gives shareholders some confidence that the company will drop a little bit more money to the bottom line, I will just point out, in this quarter, Meta had $28 billion in total revenue. Now, how do that Reality Labs, which is right now, the expression of the metaverse where all the big money is being poured into that had around 700 million in revenue? It had three billion dollars odd in expenses. I don't want to call this a money pit, it's an investment. The payoff is uncertain, it's indefinite in the future. Having Facebook pullback, having Meta pullback the spend for this year gives investors a little bit of confidence that this is still an organization that's being run with the intent to provide them some returns.

Chris Hill: Stark contrast to what we saw three months ago when the stock fell 26 percent in a single day off of their previous earnings report. You refer to something that I think is important for any business, for shareholders of any company, which is not that we necessarily want to see management teams just tale telling to whatever Wall Street wants. But there is a certain level of transparency that it behooves companies to share. The more companies can communicate this is where we're going, the more likely investors are going to get on board for that trip. I think, as you indicated, Mark Zuckerberg and his team indicating, we're dialing this back a little bit. We're still headed to the metaverse we're still going in that direction. But we're going to pull back to spend just a little bit.

Asit Sharma: I agree, Chris. At the end of the day, investors want to understand the game plan. In many cases, we, as investors, will punish a company less if we're not thrilled with a game plan, but at least we know what it is versus having that black box and just seeing the results come out quarter-after-quarter and then having to extrapolate. You don't want to do the hard work, you want management to tell you exactly what the plan is. In this case, I think it's good. Going back to your first point, just having the average daily users pop back up a little bit was comforting because you never know in this very competitive space, a crack in user growth could be a temporary thing, but it could signal something deeper and more permanent. Here, we see with Facebook, you had an increase of six percent year-over-year in their families daily active people, similar increase in family monthly active people. That gave shareholders a bit more comfort that OK we can go on with business as usual, this is still a growth story.

Chris Hill: Last thing, and then we can move on. It's always worth remembering this is an advertising business for whatever anyone's perception of Facebook, Instagram, the value proposition, privacy, all of those things. Remember, that at the end of the day, this is a business that makes its money off of advertising and they do a really, really good job of serving their customers.

Asit Sharma: If this company solely focused on advertising, it would have this unimpeded path to growth still for several years out in the future. That's how strong this business is. It's good for them to signal that we are taking care of that core business because that is where the margin comes from, that's where the profits come from to invest in the metaverse and these forward-looking projects.

Chris Hill: PayPal's first quarter revenue was higher than Wall Street was expecting, but they cut guidance for the full fiscal year. PayPal's guidance for Q2 was pretty weak. I am surprised, therefore, that shares of PayPal are up three, four percent this morning, I get that the stock has been cut in half since the beginning of the year, so it's off of a lower point than it was. I almost hate to ask this question, but I'm going to ask it anyway. Because it [laughs] speaks to a way of looking at investing that I don't invest this way and I know you don't invest this way, but when you look at the stock moving up off of this quarter and this guidance, I'm left wondering, is this an indication that shares of PayPal have hit the bottom? I'm not trying to time the bottom, I don't believe in that sort of thing. I don't know, these were not amazing results and this was certainly not great guidance.

Asit Sharma: It's a legitimate question to ask, Chris. I don't want to time PayPal either, I'm a shareholder, but I'm interested in knowing if the investment community has said enough in the stock was down what, 55 percent before this report, year-to-date and it's not a great report, I can't figure it out either. It looks to me like there's some bargain hunting going on. Potentially, investors are looking at rejiggering the growth stories, realistic expectations going forward and thinking to themselves, hey, they could accelerate in a few quarters, so this might not be a bad place to add some shares. Those who've been on the sidelines maybe see this as a little bit of settling. But I got to point out here, something funny happened on the way to world domination. PayPal of this quarter is not the PayPal of four quarters ago. I think this has something to do with the fact that there are many more specialist businesses that are attacking PayPal from various sides.

Chris Hill: They also announced they're going to be shutting their offices in San Francisco. Again, I think for all of the challenges this business has encountered, some of which are self-inflicted, I think it continues to be one of the most interesting businesses to watch for the rest of this year, both in terms of their ability to bounce back, but also just decisions like that. Obviously, part and parcel of a decision like that is, hey, we think this can save us money because I don't know if you've been to San Francisco, but the real estate is cheap.

Asit Sharma: Yeah. This is funny, Chris, because it's under-grids the point I was just making while also pointing out something good about management as your illuminating care, so they happen that they're closing the office that run Xoom, with an X, this is a money transfer business, money remittance business that competes with a lot of different players. One of those is a company called Wise which is now public as of a year or two ago, you can buy the trades in London. Wise just attacks this one thing that PayPal is very good at which is sending money abroad and working with multiple currencies, but they are a lot cheaper. They don't have to compete with PayPal over that whole platform. PayPal is looking to do a few things here. I totally agree with you, they're trying to get out of high rent district, they're trying to give employees a little bit more flexibility, and they're looking at the cost structure in this one part of the payment space they play in saying, hey, we need to be more competitive with this company because investors can choose just to buy Wise which is a more specialized company. In a lot of fronts, it's an interesting decision, it's simultaneously speaks to the difficulties they are having in the marketplace, but to management's agility, and Chris, decision-making that we've seen out of Dan Schulman for a number of years now.

Chris Hill: ServiceNow might be the most under the radar $100 billion company in America. ServiceNow's first-quarter results were great. You tell me, because is on the Service, it looks like this was their best quarter for growth in a couple of years.

Asit Sharma: Yeah, I love your description. Under the radar, most investors, I think, have a passing familiarity with ServiceNow. It's not a name that comes to mind when you ask the average retail investor to name their top five software-as-a-service stocks, but they're a juggernaut. They help big enterprises get more efficient with business process automation with workflow improvement and I think that, for me, ServiceNow, because they are so under the radar and underrated, they remind me of a certain type of tennis player. So I grew up in the small rural town, Chris, and there were three courts we could use spread across the town. One of them stood in the shadow of these tall pine trees, there was a time capsule nearby that someone had put like in the early 20th century. As kids, we literally had to play in the fall on top of pine leaves. We would skate around and I learned many life lessons there. One of the biggest being, be aware of the two-handed backhand specialist. If you've ever played tennis, you've met this player. It's the backend player who can hit the ball from anywhere on the core if it comes to their backend. It's two handed so it's powerful, it's precise, and because they always want you to hit to their backend, they have a pretty good forehand too which redirects you to getting back to that ball, and they never seem to lose. They're never going to floor you with their virtuosic but they're going to return every ball. ServiceNow has a direct salesforce team that is extremely focused, they're extremely aggressive in getting enterprise business long-term contracts at that. If you look at the metrics they reported today, sales were great. They rose, I think, 26 percent year-over-year, but the rate at which they added contracts over one million dollars, that grew at a rate of 41 percent year-over-year. They added 52 contracts in excess of a million bucks. Not a glamorous company but very dogged in the right space and I think this is yet another testament to their ability to execute.

Chris Hill: I never thought I was going to get a tennis analogy from anyone other than Bill Barker, so thank you for that. Let's wrap up on this, ServiceNow, PayPal, Meta Platforms, of these street companies, which are obviously doing very different things, which one do you think has the biggest mount?

Asit Sharma: Well, I'll go with ServiceNow not because of recency bias because it's the one we just talked about. But if we looked really briefly at Facebook, as you mentioned, they've got such a great advertising business but they understand that that also is only as good as the reach of their platforms which are prone any day to a new TikTok emerging, so they're trying to disrupt their own business building out their place in the Metaverse for that reason. They understand that moat is not as wise as it used to be. PayPal, as we've mentioned, they focus on both the merchant side and the customer side. They're really broad, they've got to compete against Square, Wise, which I mentioned, just a plethora of different payment specialists, so their moat is eroding overtime, Venmo is maturing. You look at ServiceNow, theirs is real simple, we're going to be the best at sitting across the table from the customers we do business with and convincing them to buy our product for another 3-5 years and we're going to hit the biggest companies in the world. It's not an unassailable moat. [MUSIC] Moats are never meant to be unassailable, therefore, the aggressor to try to figure out how to cross, but of the three companies, I think theirs is the clearest one to see on the ground today. That could change in a few quarters but I will give the price to ServiceNow.

Chris Hill: Asit Sharma, great talking to you, thanks for being here.

Asit Sharma: So much fun. Thanks, Chris.

Chris Hill: How do you know if a business has truly established a moat around it? To discuss that and share some stocks that know how to protect themselves, here's Matt Frankel and Jason Moser.

Jason Moser: Hey, Matt. It's great to catch-up again, everything going well for you in the family down there in South Carolina?

Matt Frankel: It is, but I am excited to get out of town this weekend to go to Omaha.

Jason Moser: I heard you were making a little trip and it feels that our topic today is quite appropriate given that you're making the pilgrimage to Omaha this weekend for the Berkshire Hathaway Annual Meeting. It's a really cool experience. I had the opportunity to go one year, I know you'll enjoy it. With that in mind, we're talking about moats today and how they pertain to investing. So with that in mind, let's just start with the most basic question, what do we mean when we say moat?

Matt Frankel: For individual stock investors, a moat is more important than looking at industry growth, market size, things like that because if you're focusing on an individual company, you need to find a company that has competitive advantages that are enough to keep its market share growing, to keep its profitability high no matter what the economy does or anything like that which is especially important in inflation and in rising rates and things like that. A moat is any company that has a durable competitive advantage that should protect its profitability and market share for the foreseeable future.

Jason Moser: It feels like for all of the great qualities that are moat can offer for investors, it's a word we hear a lot. We hear of the criticism of the company don't have any moat. Well, I think the point I've always tried to make is finding a moat is something very special. You don't see companies with just moats all around so when you find one, it really isn't essentially it. I think one of my favorite quotes really paints a good picture. There's Warren Buffett when he said I quote, "A good business is like a strong castle with a deep moat around it, I want sharks in the moat, I want it untouchable," and I think that really conveys exactly what you were saying there, just it's a durable competitive advantage that really it's very difficult to disrupt. But with that said, it's not something that every business possesses, really, only very few truly do, and over time, they can become assailable. I think that technology has really changed the game in a lot of ways for some businesses. But let's talk about businesses with moat, some of the companies you feel like possess moats today that investors should be keeping their eyes on.

Matt Frankel: Yeah. So a moat can take a bunch of different forms. Just to run down a few before I launch into a few companies, a powerful brand name. Think of a company that's synonymous with its industry. For example, you don't say I am going to search for something on the Internet, you say I'm going to Google it.

Jason Moser: Yes.

Matt Frankel: Google would be accompanied with a brand-based moat, I would say.

Jason Moser: Charlie Munger loves that. I think he's always said, what's his quote? He said, I don't think I've seen a business with a wider moat or something like that. [laughs]

Matt Frankel: Right. Amazon, which put the name above its stock, dominant scale, its name is synonymous with e-commerce for the most part and not only that it has cost advantages which is another form a moat can take because it has a massive distribution and shipping network that literally no other company can match.

Jason Moser: Yeah.

Matt Frankel: There are other forms of moats, there's a cash moat. This is what Buffett aims to achieve. This is why Berkshire has, I think, what, a $140 billion of cash on its balance sheet. Because no matter what happens in the economy, that cash not only will help Berkshire from going out of business, but gives them the flexibility to scoop up weaker competitors and gain market share. So that's another form of a moat superior products. Look at the iPhone. The iPhone is such a superior product that Apple can charge pretty much whatever it wants for it. So which allows higher margins, it keeps loyal customers. It's sucks people into their ecosystem. It's just a great all around product. The biggest Buffett stock there is is Apple, for that reason, because it's a very high moat business.

Jason Moser: Well, and I think intellectual property too is another one that we often talk about, IP, and that ranges from businesses in entertainment to technology to manufacturing. But intellectual property can be extremely valuable because it is unique, it's typically protected. I mean, it's often very difficult to replicate. It feels like, I don't know if you feel this way, but I do agree with you. I think that a brand name can be moat. It feels like it is a moat that is potentially more salable than the others just because there's the opportunity for leadership to bungled things. They can make a mess things up and they can tarnish the brands, so to speak. Sometimes you can recover from that. Other times maybe it's not quite so easy.

Matt Frankel: I love the intellectual property point. It's not just tech companies that applies to, one of Buffett's above its older stocks, Coca-Cola. It has some of the other things I mentioned. The name is synonymous with the industry known pulls up to a drive through and orders a Pepsi. No one says can I have a large coke? It's got that massive distribution network in pricing power, but how valuable do you think Coca-Cola's recipe is? That's a piece of intellectual property that is a big moat to that business because it's not just that they have that brand name, but their product taste better. Ask Buffett, he'll tell you the same thing. [laughs] Intellectual property is the only reason the BlackBerry Corporation didn't go bankrupt because of the iPhones dominance. It's because they have so many patents in their portfolio and own so much of their intellectual property that they were able to stay alive even though their market share went away. Intel is another great example of a company with a ton of intellectual property that gives it a big moat. They're the most commonly used processor by computer makers and they own the patents to so much of their technology that it prevents more than one or two other competitors from even competing for their market share.

Jason Moser: You could also look at businesses and think, well, they have more than one moat too. In some ways, I mean, if we look at Disney as an example, I mean, Disney obviously has a tremendous advantage in that intellectual property, but that intellectual property serves many different purposes, and the theme park side of that business is obviously a crucial part of it. Just the physical nature of that theme park side of the business, that's a very, very difficult thing to replicate. All of the news that's going on right now with Florida and the governor there, back-and-forth, and people are saying, Disney to just pick up and leave Florida. You know what, it's not quite that easy. [laughs] They've spent decades building out this massive presence there, that physical infrastructure, that physical presence is very difficult to disrupt. So you can find companies actually that have multiple moats, I'd say.

Matt Frankel: Disney World's like the size of Rhode Island, you can't just pick it up and move it.

Jason Moser: No.

Matt Frankel: You're right. There are companies with multiple moats, like some of the ones I mentioned, Coca-Cola, distribution network is superior. That gives a cost advantages. It's got pricing power because of that brand name. It's got intellectual property because of its recipes. The name is synonymous with its industry. Apple has several different competitive moats. Berkshire itself has several different competitive moats. They sell a product that people need and have brand recognition. GEICO. Can you name a company more recognizable in the auto industry space than GEICO?

Jason Moser: No. Might be Progressive.

Matt Frankel: Might be a distant second. Even within the business, there's a lot of different competitive moats. Utilities. Utilities have near monopoly in the areas they operate. A ton of competitive moats in the utility business. Just a ton of different competitive moats and you're right, companies are not limited to just one.

Jason Moser: What are some of the things just as it for investors that are looking to identify moats. I mean, I feel like we've hit on this, but if there's something in particular, part of your process, something that you use as a starting point in order to try to find business that has moat, like identifying that motor, their metrics, or are there things that you look for in order to be able to really ascertain, yeah, this business has a moat or no, it doesn't.

Matt Frankel: I can name two screening factors that will help you narrow down to like five percent of the companies in the market. One, how did the earnings holdup during tough times? If earnings continue to grow during, say, the financial crisis or during any recession, that's number 1. Number 2, companies that have a decade plus history of growing their market share every year. If a company can continuously grow its market share, especially at a competitive industry like technology or consumer products or things like that, if a company can continuously grow its market share, like Amazon continues to do, that's a great way to narrow down companies with wide moats.

Jason Moser: Well, it makes a lot of sense to me, Matt, and it's always great catching up with you. Safe travels this weekend. Are you going to be providing any real-time coverage while you're there? How can we follow the Matt Frankel Berkshire experience?

Matt Frankel: I will be on The Morning Show for two hours the following Monday to do a recap, and I will be live tweeting at the event while questions are going on, that's pretty much the best way to follow me @TMFMathGuy.

Jason Moser: [MUSIC] @TMFMathGuy. Follow him, keep up to speed with what's going on in Omaha this weekend for the Berkshire Hathaway Annual Meeting. Matt, enjoy it. I'm sure you'll have a blast.

Matt Frankel: Thanks, Jason. Always good to be here.

Chris Hill: As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.