The Might (and Myths) of Economic Moats

Tyler Crowe (0:03)

The Might and Myths of Economic Motes. Motley Fool Hidden Gems Investing starts now.

Welcome to Motley Fool Hidden Gems Investing. I'm your host, and today, we're gonna change things up a little bit. As we're taping, this is actually a prerecord, because as you're hearing this, we are all at FoolFest, which is a annual live gathering of Motley Fool members. We do a lot of Q&A and things like that, and several of us, as well as production team, are gonna be there, so we needed to get something to you guys. Well, this is a prerecorded idea. I'm with Jon Quast and Lou Whiteman, as always, and what we're gonna do is we're gonna talk about the concept of economic modes. It is a very common or a very well-tread term that's used in financial media a lot as a way to analyze businesses. It became very popular in the 2000s. I think, Jon, you're gonna talk about that a little bit. But I think for most beginner investors, understanding economic modes, what they're good for, why they might not be so good, and maybe some examples that will help kind of guide people into how to use this, be a little bit helpful for them and a great kind of evergreen content we can do. So Jon, I want to start with you because you were talking about a book and I've actually got it. We can use it on video here.

When you hear economic motes, what exactly are they?

Jon Quast (1:25)

Yeah, an economic moat, this is basically something that a business has that makes it harder for the competition to compete against it.

Pat Dorsey wrote a great little book called The Little Book That Builds Wealth. And in that book, it identifies four different kinds of motes. I think this is a great book to read if you're a newer investor in particular, but the four categories that Dorsey identified was first, intangible assets. So this could be like your brand, for example. It's not something that exists on a spreadsheet. It just kind of exists out there intangibly. So an intangible asset can be a mote. Switching costs. So how painful is it to switch my business from this company to that company? Switching costs. Network effects.

Think of a marketplace that has buyers and sellers. That's a network. A larger network is a greater kind of advantage. And then there's also cost advantages. So some companies can actually, for example, build their product for cheaper than a competitor for XYZ. Fill in the blank. So these things make it harder for other companies to come in and compete against your business. And so you have a mote. It's just like you have your little castle and around it is a body of water that prevents the night from coming over.

I want to give an example that maybe you haven't even heard of before. Around the year 1900, it was a great place to do business in Buffalo, New York, and there was a couple of reasons for that. Buffalo, New York was able to have more reliable energy than almost anywhere in the world at that time because of the power plant with Niagara Falls. And then there was also access to the Great Lakes by extension the Mississippi. So you could go out west, and then you could also, through the Erie Canal, go to New York City and then the world. So if you were a business building in Buffalo, New York in around 1900, you had cost advantages, both on the energy side and then also on the distribution side. If you were a business trying to compete in Pittsburgh, you didn't have those advantages. It would have been hard to compete against a business in Buffalo. So that's one of those things that, at that time, would have made it very hard for any company to steal business from a company that was thriving in Buffalo.

Lou Whiteman (3:45)

I feel like I was called off the bench here like wrestling style to just be the heel or deal like, oh, we're talking motes, let's get Lou on. But yeah, I am a motes skeptic, and especially I love Jon's example there because the thing is, is it didn't work out over time for Buffalo. And so that's the big thing. What we're talking about here is competitive advantages. And competitive advantages tend to not be all that permanent. I mean, motes, if nothing else, I think the concept is overused. I feel like it's like recession. For every 10 that are declared, maybe we'll have one. And I got to be honest, I don't think about motes in my investment process because I really believe that A, they're rare and B, they are almost impossible to identify in real time. Only in hindsight can we look back and say that was a mote.