What are Moats? Part 2: Intangible Assets & Intellectual Property
As we concluded in the previous article, having a certain moat is crucial for companies. A moat distinguishes a business from its competitors and provides a competitive advantage. This competitive advantage grants you pricing power. With pricing power, a company can sustainably increase its prices, leading to higher revenues and profits in the long term. The extent of a company's pricing power depends on the size and strength of its moat and how well it differentiates from the competition in its sector. As a shareholder, it is important to thoroughly analyze a company's moat before deciding to invest.
As we defined in the previous article, there are different types of moats. In this article, we focus on the moat related to Intangible Assets and Intellectual Property (IA & IP). These are the non-tangible assets on a company's balance sheet, often including brand names, patents, and trademarks.
MOAT FROM BRAND STRENGTH
A company has an IP moat if its brand name provides certain pricing power. Examples include Hermès, Ferrari and LVMH. These companies leverage their well-established brand names to price their products above standard market prices, such as bags, sportcars, clothing, and perfumes. Due to their strong brand names, these companies can charge a premium for their products. Brand perception and marketing are key to maintaining brand strength. For instance, LVMH spent 12% of its total annual revenue in 2023 on marketing costs (LVMH, p. 9). LVMH could significantly increase its profit margins in the short term by cutting marketing expenses. However, in the long term, this would harm the company as it would diminish brand strength.
Other examples include McDonald's, Domino’s Pizza, and Chipotle Mexican Grill. All three companies have successfully increased their prices faster than inflation over the past decade, partly due to their strong brands and high-quality products within their sectors, which mutually reinforce each other.
As a potential shareholder in IP moat companies, you should evaluate brand strength. Current shareholders also should regularly assess this strength. If there are signs of a weakening brand strength, shareholders might consider selling their shares if their investment thesis is compromised.
For instance, Under Armour's stock price has significantly declined in recent years, dropping 85% from $42 to $6 per share since 2016. While the causal link is unclear, the company has conducted significant discount campaigns to sell off old inventory. Currently, Under Armour offers approximately 28% of its total assortment at a discount in its ‘Outlet’ (446 discounted items out of 1,561 total items, source: Under Armour).
Short-term revenue increases from discount campaigns can please or reassure shareholders, but prolonged discounts can reduce perceived brand value and growth rates in the long term.
If LVMH starts selling Louis Vuitton bags at a discount tomorrow, they will boost their revenues quickly. However, if this discounting continues over a longer period, market saturation would reduce brand perception to the discount level. In this scenario, Louis Vuitton would lose brand value due to decreased exclusivity and increased product visibility.
The image of an IP moat company is crucial. If this image is damaged, investors need to reassess their positions. However, temporary brand damage can also present buying opportunities. For example, Chipotle Mexican Grill suffered reputational damage in 2015 due to a food safety scandal involving the norovirus and E. coli. Chipotle's revenue dropped 30% year-on-year in Q4-2015, resulting in a net loss of $26.4 million compared to a $121.2 million profit in Q4-2014, reversing the operational leverage effect. Shareholders felt this impact as Chipotle’s market value fell by $10 billion.
Should you sell all your shares as a shareholder in such cases? Or should you buy more? This depends on several factors, such as the extent of the reputational damage and the management's response. Does management act as if nothing is wrong, or do they take the issue seriously and work hard to resolve it with honesty and transparency?
Investing during tumultuous times can lead to high returns if the company recovers and restores its reputation. However, the risk is also greater. As a shareholder, you should evaluate the risk-reward ratio and determine whether investing in the company during a crisis is worthwhile.
MOAT FROM TECHNOLOGY (& PATENTS)
Besides brand names and trademarks, a company’s balance sheet also may include patents and related technologies, often resulting from intensive research and development (R&D). These non-tangible assets fall under Intangible Assets.
An example of a company in this category is the Dutch company ASML. ASML has continuously invested in R&D over the past decades, achieving a monopoly on EUV lithography systems. ASML's technology is so advanced that no other company in the world can currently build such a complex chip machine. These R&D expenses and technological advancements are often protected through patents. Looking at ASML, the company holds about 20,000 active patents (source: Insights by GreyB).
As a potential shareholder, while looking at a possible moat by technology, you should focus on innovations, R&D, and technological developments within the company and the sector. Hereby it is wise to evaluate the company’s long-term strategy of how it will strengthen its moat and lower the potential risks from disruption by competitors or substitutes.
Technological IA moats can develop faster than brand strength and IP moats, especially in the current era of technological advancement, such as the ongoing AI revolution.
For example, decades ago, Nokia began losing market share to competitors like Samsung and later also to Apple. Monitoring market share trends within a competitive sector is advisable. Although it doesn’t predict the future—Nokia could have introduced a successful new smartphone—it often indicates a trend investors can follow to assess a company’s IA moat and the capability to innovate. Successful companies usually have larger R&D budgets, giving them the best prospects for future success.
IP and IA moats can also converge, as seen with companies like Apple (one of the world’s most valuable brands with numerous technological patents) or Volvo (a car brand name built on safety through technological innovation). A strong brand name, patents, and trademarks provide a competitive edge. When you are in the process of investigating an IA & IP moat of a company, ask critical questions and monitor the development of these moats.
In the next article – Part 3 of this series – we will focus on the Switching Costs moat of companies.
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