In this podcast, analysts Jim Gillies and Iain Butler from Motley Fool Canada join Motley Fool producer Ricky Mulvey to discuss:

  • What it means for a company to have a moat.
  • Key metrics that can show whether a company has a competitive advantage.
  • Moats in utility poles, engineering software, and "gentlemen's clubs."

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Jim Gillies: This is almost an example I mentioned earlier, where they took over a mountain no one else really knew they wanted, and you've built a really nicely cash-generative business on top of that. Then as long as management makes good capital allocation choices with the cash they generate, you can start getting some pretty decent returns.


Chris Hill: I'm Chris Hill, and that's Jim Gillies from Motley Fool Canada. Ricky Mulvey caught up with Jim and his colleague Iain Butler to talk about companies with unusual moats.

Some competitive advantages are well known, but let's face it: some economic moats just aren't that obvious, like utility poles, engineering software, even gentlemen's clubs. In this episode, Jim and Iain talk about what makes something a moat and the metrics that can reveal a true competitive advantage.

Iain Butler: There's a lot of ways that a company can create a moat, but I think that's really what it comes down to, it's just your ability to sustain a competitive advantage over a long period of time. Is there any other fancy definition or way of describing it in your mind?

Jim Gillies: One that I like to refer to, I'm not sure it's ever been really... the textbooks doesn't get equated to moat. Companies that go after industries that nobody else wants. I think we've got a few examples of that planned for you today, but you took control of a mountain no one else knew they wanted. Then at the end of the day you realize, oh, this company controls this subspace. It doesn't have to be something terribly exciting and sexy, like Internet security. Sometimes, you can find it in some pretty weird little niche places that no one else realizes wasn't a great opportunity, except one or two companies basically go in and seal it up for themselves.

Ricky Mulvey: We're going to get weird in a little bit. Jim, I remember in some previous conversations about franchise businesses, your personal favorite, you said that you're okay paying a higher multiple on a franchise business, because you know that it's a reliable check-cashing machine. How does a moat fit in your investing framework, and do you ever find yourself saying ,"You know what, it might be worth paying for this overvalued company on other metrics because it has such a wide moat?"

Jim Gillies: Well, one of the best things you can find of course if you can find one of those widening or nascent or super-wide moats, if you can find that for the bargain price, that's the holy grail. But yeah, I'm fine... One of the symptoms of a moat company for me is they can generally have pretty good carte blanche in raising their prices, controlling their prices.

We talked briefly before the show, one example that I have, a private company I know, but they can charge pretty much whatever they want, because when they talk to their customers, there's something like 0.001% of the typical company operating budget, so no one's going to care. They're just going to like, oh, if the supplier company decides to double or triple their price, the customers don't really notice.

What ends up happening is moated companies, if I can use that as a word, moated companies tend to have pretty good pricing power. They tend to be very good cash generators. And then you hope they're good capital allocators of the cash they generate.

Iain Butler: I think just to build a valuation case, I'm just trying to think through some examples that I've experienced over the past, I think you really have to get into the small-cap world to find a valuation case when it comes to a moat. These megacap companies certainly have moats, but valuation outside of crisis times in the market is rarely ever a reason to buy those companies.

Autodesk is one that comes to mind. It's a recommendation that we've made in Stock Advisor Canada. It's in several services across Fooldom. I wouldn't say there's a valuation case for Autodesk, but I would say that there's an incredibly strong moat associated with Autodesk, which I think, in that case, can overcome any valuation concerns that one might have.

Ricky Mulvey: Just for some context, that's the one that a lot of engineers use, where if you're building out a building and you want to make sure that your electrical engineers and your plumbing folks are operating on the same system.

Jim Gillies: This is my engineering ring as the former engineer on the panel, let me tell you that the AutoCAD moat is very, very real. It is basically all you learn to do, and if you want to have portability from one job to another in the engineering space, it's all Autodesk, it's all AutoCAD.

Ricky Mulvey: It's difficult for the listeners to see. I just saw you sticking a finger up at me, and not the other one. 

Jim Gillies: You American types don't wear engineering rings, but in Canada, the engineer, is a supposedly solemn ceremony where there's a Rudyard Kipling poem. It's less serious than they make it out to be when you realize when you go in, but it's still fairly... It's supposed to be a commitment that engineers will not pass shoddy work, will do the best for the public, blah blah blah.

Ricky Mulvey: But I would talk about some obvious moats, because there's some intro folks out there, and I think it's a good way of illustrating how a company becomes essentially a megacap or a larger-cap company by just building either like a balance sheet up or just a vertically integrated system.

When I think of an obvious moat of a company you know, I think I would actually go to Live Nation. They own Ticketmaster, they own the venues, they manage the ticket sales, they manage the artists. If, Jim Gillies, you want to see Death Cab for Cutie, it's a very important band, it's not like easily substitutable for another jam band like Goose or the Dead and Company. You want to see Death Cab for Cutie, you're going through Live Nation.

Jim Gillies: I have gone, and I have recently twice.

Ricky Mulvey: Then to your earlier point, Iain, it's something you're going to pay for. I think right now the stock's trading at about 100 times earnings or something like that. When you think of obvious moats, I know you've got one, Iain, so I'll start with you. What is just an obvious fastball, straight-down-the-middle moat that you can think of?

Iain Butler: The company that pops right into mind is only a company that I've come to know over the past year. I suspect that if indeed we have some relatively new investors listening, they will not have heard of it. It's a big company, I don't have the market cap up handy right now. Dutch company by the name of ASML [Holding].

ASML essentially is the ground floor in the entire global semiconductor industry. They make the machines that go into the manufacturers of semiconductors, and they're behind manufacturer semiconductors. Intel as a client, Taiwan Semiconductor as a client. All these massive semiconductor companies are reliant on the machines that ASML makes, and they have such a lead in technology.

That lead is expanding as each new generation of machine comes out. These are hugely expensive machines, I think they're nine-figure machines for one. They sell 30 machines in a year or something like that. I don't even think anybody's even trying to compete with them. They're that far ahead, and the capital is so intensive that it just doesn't make sense to compete with them. That's been a company that I've learned about, again in the past couple of years, that has just blown me away at its competitive strength and the depth of the moat there.

Ricky Mulvey: Let's move to some less obvious ones. I want to talk about pool equipment. You guys countered with rail ties and compressed wood. This is a company that makes utility poles, which is a product that is quite literally grown on trees. We're talking about Stella-Jones.

Why is Stella-Jones a company with a hidden moat?

Jim Gillies: Well, if you want me to take the first kick at it, it's a company that both you and I have recommended on our respective services in Canada. If nothing else, we apparently like railway ties and utility poles, which of course, are there.

Ricky Mulvey: And talking about them.

Jim Gillies: Yeah, exactly. But seriously, you get railway ties and utility poles. How excited are you? Or what do you call it? I think you, Iain, call them the national tree of Manitoba or something like that. The utility pole. 

Iain Butler: Somebody wants called driving through Nevada on a mining trip once. That's what was pointed out. The telephone pole is the national tree in Nevada or the state tree of Nevada.

Jim Gillies: The state tree of Nevada. But it's a moat for similar reasons to what I discussed earlier, where the dollar value of what they're putting in for railways. Railroads are massive, massive capital-intensive businesses. That's part of why Buffett when and bought a railway for Berkshire Hathaway, because we want to be able to reinvest tremendous amounts of capital at ideally high rates of return.

But to maintain these massive networks is a lot of money per year, and the compressed wood, the creosote-soaked railway ties, there have been pretty much the same since the 1800s? I think I know there's concrete railway ties as well, but these are fairly simple, fairly localized. There's only a few companies that do this stuff and Stella-Jones happens to be, I believe the largest one, certainly in North America, and they are able to essentially pass along their cost plus, in inflationary environments. No one's good about, and I lost the big railway company is not going to bat about an eyelash at what Stella-Jones is requiring to have them, really happened pay.

You essentially have, it's like the water chemistry example. Stella-Jones can push through their price increases, maybe a little bit more for their pain and suffering, and the railway companies are just going to "Cool, that's fine." This is not a product that they're going to switch out for a young upstart competitor, in the creosote-soaked wood, comes along and says, "Hey, we'll beat Stella-Jones's prices by 5%." It's not going to go because you're not going to switch back and forth. They just going to go no.

On the utility side of things, quite often municipalities have multiyear contracts with Stella-Jones to keep them supplied with the state tree of Nevada. I've always loved that line. This is a company that they've got products... We're going to get to a better example. But this is almost an example I mentioned earlier, where they took over a mountain no one else really knew they wanted, and you've built a really nice cash-generative business on top of that, and then as long as management makes good capital allocation choices with the cash they generate, you can start getting some pretty decent returns.

Ricky Mulvey: Do they have any? I've always seen utility poles as commodity, and to be honest, I haven't really seen utility poles and thought much of them. Are there any real competitors in this space, or is this a market-share leader that has just completely claimed the mountain you just described?

Iain Butler: I think any competitors that are out there are minuscule in relation. They're sort of the big dog in the pound.

Jim Gillies: Yeah, we've got a member of a couple of Fool services who we know because we've interacted a couple of times on Twitter, and he does work for a competitor of one of, like basically they go out and harvest the trees. He's in the tree harvesting business, but for a competitor of Stella-Jones, and he has only said in our brief conversations, he's only had positive things to say about Stella-Jones and remarked on they're a hard company to compete against.

Ricky Mulvey: This is also a company, though, where growth is fairly predictable. They can project their revenue pretty well, I would assume. But it's also a case where the company's valuation has gotten ahead of itself before. For the old retail folks, what are the metrics to really watch with this company to make sure they're not paying too much for their utility poles?

Iain Butler: I think that's what's historical, I mean, so it was one of the best-performing stocks in the Canadian market up until a few years ago, when it's flatlined a bit, and that's right.

The multiple has historically been very high. It's not high now and it hasn't been high for a couple of years. I think, at worst, if you just can get this company for its growth prospects alone, for consistent, as you say, predictable revenue stream growing with inflation and whatever else, any contractual increases it can make, great.

But I think there's a case right now, especially when there's potential multiple expansion involved. Like historically it's sort of been at 20-, 25-times-earnings type company, and here we are half that. I think there's a good total return equation in play right now I think, and it's one, two where you could probably let it go when it does get more fairly valued. It doesn't necessarily have to be a buy-and-hold-forever type situation despite its competitive position.

Jim Gillies: Yeah. To build on that, the valuation, I think is really something you want to watch for this moaty company. And I think people should be aware of that they were doing very, very well on the Toronto Stock Exchange, and they kept on touting that even though it kind of stopped after about 2015. The company itself will put out a press release or a slide deck showing how, oh, they've beaten the market, they beat the S&P 500, they beat the cap industrial index and the S&P TSX, and then you look at how they did it. It's like, well, but that's a 10-year chart. Actually it was a nine-year chart when I was looking at it about a year ago.

And if you lopped off the first two years, all of a sudden, Stella-Jones went from a market smasher to, I think from about March of 2015 through to the end of 2021, I think it's annualized return was about 0.7% because to Iain's point, they had gotten out ahead of their skis valuation-wise. They'd become this darling, and so people forgot about them, and the stock meandered down. And so when we were looking at them and recommended them, I don't remember what, Iain, you put them into Stock Advisor at. But by the time we came along to them, and I think we went first in Gems, if I'm not mistaken, but Iain has talked about 25 times earnings was where these were hovering.

By the time we came along to them, I think we're at about 11 times earnings, so we got it at a much better price, and then as Iain says, we're looking for multiple expansions. Not only are they growing earnings and growing revenues and growing cash flows and paying you a higher dividend and buying back stock, but maybe if they ever go back to that 25-times multiple, we're going to get 100%, 150% return on our cost basis just from the multiple expansion. Forget about the business growth. And that maybe doesn't sound great if you go back and look at the 2020, early-2021 growth-stock frenzy.

But historically, that's the aberration in the market, and we know grows 10%, 11% annualized with dividends reinvested. This suddenly becomes a very good argument for buying Stella-Jones at roughly the present valuation level.

Ricky Mulvey: Next company could not be more different. This is a company that operates a chain of strip clubs, nightclubs, sports bars, and restaurants. It's also a media and convention company that serves the adult club industry. It's RCI Hospitality, formerly known as Rick's Cabaret.

Jim, when you presented this, first of all, I had to make sure it was okay for us to talk about on the show. But second of all, when you presented this, I understand how this business is profitable, but what I don't understand with RCI Hospitality is how it has a moat when it has quite a few competitors. 

Jim Gillies: I'm going to suggest to you, not only does it have a moat, it's got multiple moats. I do thank you for kind of running it through the proper channels. Because it's a legal business, but I obviously understand that there could be disparate opinions about this type of business, and so of course, no one has to own anything they're not personally morally comfortable with, of course.

But in my particular town where I live in Southern Ontario, there is one approved location for this type of business. It's actually housed -- it's not owned by RCI, but I'm going to I get to why it applies to RCI here. It is owned by an individual. It's in a historically significant house for this town where I live. It's actually in a Heritage building. For the last two decades, they've said to the city, "We want to move out to more to the industrial ends of town" thing, and we would sell you the business or sell you the building. And the city says, "We have grandfathered in there will be no more of these types of businesses approved in this town."

Nothing has happened, and the place is still where it has been for decades. That's a kind of moat. Literally, if they close or move, that service will be gone from the city, and that's what's going on for RCI.

They quite often, they own the only approved, allowed, grandfathered-in locale for gentlemen's entertainment club kind of thing. "Strip club" sounds so sordid. They literally have a localized government-granted and -enforced moat. They don't have to go out and advertise and try to beat back the competition coming in and setting up across the street from them or across... They're legislated in, and so what ends up happening, a lot of these things have also been sole proprietorships, and RCI is going in and buying up the sole proprietorships or like individual businesses, they're buying them up at relatively low valuations because, it's another example of it's a mountain no one else realized they wanted. They're buying at 3, 4, and 5 times EBITDA when they take over someone looking to sell one of these locales. They go in. They pay a relatively low valuation, and they're grandfathered in.

Again, whether you agree with the business model or not -- and I certainly can see the arguments on both sides, to be honest with you -- there is some value in a localized government-granted moat, and one of the best-performing stocks in North America in the past 75 years is Altria, aka Philip Morris, aka the Marlboro cigarette people. One of the reasons it's been so successful has been the tremendous external pressure against owning companies like that. It's kept it at a low valuation. That company as well, they don't have to advertise cigarettes anymore. They don't have a lot of R&D budget. They make a ton of cash. They pay a ton of taxes, they make a ton of cash and roll that cash continually into raising their dividend and buying back shares, and they do so at a really low valuation because of the external pressure.

And that's what I mean, what's unsaid here is since we started looking at RCI Hospitality about two-and-a-half years ago, I think the stock... Because that's the same principle coming forward here is, I said to Iain in the past, this is probably, even though given the controversial nature of the business, it's probably not one we want to recommend. But I think it's worth looking at for people who don't mind the morality of the business. I think it's worth looking at, because I hold RCI Hospitality as, it's probably got one of the best and most comprehensive well-thought-out plans for delivering their free cash flow. What they're going to do with their cash in their whole capital allocation stack.

At this price, we're going to seek tuck-in acquisitions. At this price, we're going to seek dividends, dividend hikes, maybe a special dividend. At this price, we're going to be looking to buy back shares. And I think they've done really, really well. The CEO, he was a big fan of the book The Outsiders, which is all about capital allocation and rock-star companies that have done well with it. And he read that about five or six years ago, and I think he embraced it as how he wants to run RCI Hospitality.

And so again, you're focused where there's a lot of real good positives that we would like with a lot of stocks in the Foolish universe. But there is that business that maybe no one else wants, and so you go, that's an interesting combination to me.

Ricky Mulvey: It's a company you want to ask questions about, and Glassdoor ratings are always something that can be juiced and you want to look with a more critical eye, especially for a smaller-cap companies. 94% of employees would recommend working there to a friend. If this is your space, it sounds like it has an incredibly high employee score, I would say.

Let's move on to some final questions. I think the thing about moats, and you were talking about this earlier with some companies, is they can end up being stocks that you own but don't really pay attention to. And that's exactly the case with a company like Pool Corp., which is not selling pool supplies to consumers but rather businesses, and it's not a stock I own, but it's 20 times larger than its second competitor, and that would give it, I would say, a pretty strong vote in a space, in a hill that not too many people else are at or on.

Jim Gillies: Yeah. It's definitely I think I said before, I actually own it, and yeah, I couldn't tell you the last time I went and looked at their filings. Just because it's not one that I worry too much about. I would encourage people who are interested in Pool Corp., go have a look at their historical returns, how they've done in terms of returns on capital and then what they've delivered to shareholders. It's been -- to long-term shareholders. Again, this is not something that you should be jumping in and out of I think. Iain?

Iain Butler: Actually, you just raised a question that I threw into our notes ahead. Do either of you key on a specific metric to provide some indicate that a moat might be present? Is there is there any one number that you look to and go, this is an interesting competitive situation potentially.

Ricky Mulvey: I'm honored you asked me but I have no idea. I'm going to punt this to Jim.

Jim Gillies: I'm going to say no, disappointingly. I'm a cash flow guy, so I look at cash.

Iain Butler: I think that's the answer. The two that came to mind when I was asking myself that question, as I was looking at some of these companies that we threw into the air, I think an improving margin is one. An improving operating margin indicates pricing power potentially and the ability to sort of get more out of your customers and what you're having to put into them cost-wise. I wonder about return on equity as well. Like a high return on equity might be an indication.

Jim Gillies: Maybe more return on capital. Because especially in a world where we've seen a lot of companies blow up their balance sheets with buybacks, and yet that's going to keep your equity account low and it's going to float your ROE higher. Maybe more of a return-on-capital thing I would argue for.

Iain Butler: But I think that maybe the message then is, it's a mosaic approach. There's no real like one thing that any of us are going to point to and go boom! Moat. It's like you got to understand the business.

Jim Gillies: I love the "mosaic approach" analogy. That's very Charlie Monger review. I think that's where I first heard that, and I think that's great.


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.