Later tonight I’ll be giving a presentation at the Boston College Investment Club on why we should sell our largest holding, Village Super Markets (VLGEA) - a pick that has outperformed the S&P 500 by nearly eight-fold during the club’s holding period.

In creating my presentation, I kept coming back to one central concept - that of an economic moat, or durable competitive advantage. The supermarket industry has no moat, as it is almost all pricing competition open to anyone who can raise the working capital. This becomes obvious when you consider industry net margins, which are flanked on the lower side by broadcast radio and airlines and on the other by music/video stores and auto dealerships… not the most thriving business groups I’ve ever seen.

So what is it that creates a moat? The four examples I use in my presentation are:

1. Incomparable Economy of Scale
2. Network Effects
3. Intellectual Property Rights
4. High Switching Costs

Since the entire purpose of this exercise is to sell VLGEA and reallocate that money somewhere with a higher expected return, what I’m hoping happens is that this capital - currently invested in a no-moat business trading for 14.2x earnings - is turned around and reinvested in a wide-moat business. Call it “moat arbitrage,” and according to Google, nobody has ever used that term before.

What would moat arbitrage be? I’d say it is a fancy term for selling the stocks of companies with no significant competitive advantages and buying the stocks of companies with huge competitive advantage that are trading at a discount relative to the no-moat firms. With VLGEA trading for 14.2x earnings and unlikely to grow earnings significantly faster than long-run U.S. GDP (say, 3%), what businesses can be found with one of the four characteristics above and still trade at similar or lower multiples to VLGEA? I submit the following:

Economy of scale: Wal-Mart (WMT) trades at 13.25x forward earnings
Intangibles: Disney (DIS) is at 14.6x forward as estimates are being raised, Nike (NKE) at 15.5x next year’s estimates, Johnson & Johnson (JNJ) at 13.5x forward
Network Effects: American Express (AXP) at 12x next year’s estimates, EBay (EBAY) at 14.7x forward
High Switching Costs: Oracle (ORCL) at 13x forward

There are plenty of resources available on the stocks above, and I’ll likely be talking more about those companies soon, so I’d like to close this out by offering a few more thoughts on the supermarket industry - which also apply to businesses with no moat generally.

In my research, I found that 2% net margins tend to be the topping point for the supermarket industry in particular. If you look at the industry summary on Yahoo, you’ll see this is generally accurate give or take a few dozen basis points. The outliers on the upside should be viewed suspiciously because they’ll have some non-comparable trait like residing in the country of Chile, or have net margins more artificially inflated than Barry Bonds’ hat size thanks to booking more than $100 million in one-time gains when real income from continuing operations is negative - not that I’m singling out The Great Atlantic & Pacific Tea Company (GAP).

Also, when it’s crucial to drive higher volumes (i.e. same-store comparables growth) to “make it up on the backend” like supermarkets need to do with inventory turns, pay careful attention to where the growth is coming from. Is it moving more product, or moving the same amount at higher prices? In Village’s case, they can point to 3.6% same-store comps growth and a 4.8% sales increase in general, but COGS was up 5% overall. Perhaps this isn’t surprising seeing the high degree of cost inflation in pretty much every food category out there, but it is worth differentiating this - and Barry Ritholtz is particularly good at doing so.

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