Dear investor,
As mentioned by Warren Buffet, “A good business is like a strong castle with a deep moat around it. I want sharks in the moat. I want it untouchable.”
For most people, it’s common sense to pay more for something more durable. From kitchen appliances to cars to houses, items that will last longer are typically able to demand higher prices, because the higher up-front cost will be offset by a few more years of use. Quality items command a higher price and most people understand this concept.
The same concept applies to the stock market. Durable companies—companies that have strong moats—are more valuable than companies that don’t have much of an advantage over their competition.
This is the biggest reason that economic moats should matter to you as an investor. Companies with strong moats are more valuable than companies without moats. So, if you are able to identify which companies have economic moats, you will limit your purchases only to companies that are really worth it.
Moats
In a famous 1999 Fortune article, legendary investor Warren Buffet wrote, “The key to investing is determining the competitive advantage of any given company and, above all, the durability of that advantage. The product or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”
Whenever a company develops a profitable product or service, it isn’t long before other firms try to capitalize on that opportunity by producing a similar version, or even improving on the original version.
We know from microeconomics that in a perfectly competitive market, rivals will eventually compete away any excess profits earned by a successful business. For instance, Nokia boasted the majority share of the mobile phone market for several years, but the introduction of Apple’s ¡Phone in 2007 and the subsequent evolution of the smartphone market left the flat-footed Nokia behind.
A similar shift has occurred in the gaming industry, where longtime powerhouse Nintendo is seeing its iconic, family-friendly franchises left behind by powerful new consoles boasting high-end third-party software, such as Microsoft’s Xbox and Sony’s PlayStation. Meanwhile, mobile devices have begun to erode Nintendo’s dominant position in the handheld gaming market.
In other words, profits attract competitors, and competition makes it difficult for firms to generate strong growth and margins over the long term.
But there are definitely some companies that manage to earn high returns on capital for extended periods of time. These companies are able to withstand the relentless onslaught of competition for long stretches, and these are the wealth-compounding machines that investors want to find and own.
It’s important to note that an economic moat must be a structural element of the business itself. Investors shouldn’t look for companies with better short-term execution than competitors, or cyclical improvements that make returns on capital look good, they should look for companies, where the business and industry structure protect profits.
Along these lines, while great management can certainly enhance a company’s moat, just as poor management can detract from it, management itself cannot form the basis of an economic moat.
Moats and Value Creation
To understand why strong competitive advantages increase the value of companies, let’s think about what determines the value of a stock. Each share of a company gives the investor a small ownership interest in that firm. Just as an apartment building is worth the present value of the rent that will be paid by its tenants, less maintenance expenses, a company is worth the present value of the future cash flows the business is expected to generate over its lifetime, less whatever the company needs to spend on maintaining and expanding its business.
So, let’s compare two companies, both growing at about the same clip and employing about the same amount of capital to generate the same amount of cash:
One company has an economic moat, so it should be able to reinvest those cash flows at a high rate of return for a decade or more.
The other company does not have a moat, which means that returns on capital will likely plummet as soon as competitors move in.
The company with the moat is worth more today because it will generate economic profits for a longer stretch of time. When you buy shares of the company with the moat, you’re buying a stream of cash flows that are protected from competition for many years. It’s like paying more for a car that you can drive for a decade versus a clunker that’s likely to conk out in a few years.
How much value a company will create for itself and its shareholders depends on two things:
The amount of value currently being created
The business's ability to continue to create value well into the future
The first factor is widely known by the market because it’s easy to calculate using basic financial statements. It’s the second factor, the magnitude and duration of future excess returns, that is harder to determine but is ultimately more important for successful long-term investing.
For example, take three companies, each with a similar value-creating return on invested capital (ROIC) today. The company that is able to sustain those excess returns the longest is going to be able to add the most value for itself over the coming years.
Therefore, a big reason that moats should matter to you as an investor is that they increase the value of companies. Identifying moats will give you a big leg up on picking which companies to buy, and also on deciding what price to pay for them.
Moats Matter for Many Reasons
Why else should moats be a core part of your stock-picking process?
Investing in businesses with strong moats can protect your investment capital in a number of ways. For one thing, it enforces investment discipline, making it less likely that you will overpay for a hot company with a doubtful competitive advantage. As mentioned before, high returns on capital will always be competed away eventually, and for most companies and their investors, the regression is fast and painful.
Think about all the companies whose competitive advantage disappeared overnight when another firm launched a better widget into the market. It’s easy to get caught up in fat profit margins and fast growth, but the duration of those fat profits is what really matters. Durability is the key when assessing competitive advantages.
Moats give us a framework for separating the temporary here-today-and-gone-tomorrow stocks from the enduring companies with real sticking power. Also, if you’re right about the moat, the possibility of a permanent capital impairment declines considerably.
Companies with moats are more likely to reliably increase their intrinsic value over time, so if you end up buying their shares at a valuation that in hindsight is somewhat high, the growth in intrinsic value will protect your investment returns.
Companies without moats are more likely to suffer sharp, sudden decreases in their intrinsic value when they hit competitive speed bumps, and that means you will want to pay less for their shares.
In other words, the quality of the business determines how wide the margin of safety should be. On one hand, if you invest in a high-quality business you can afford to pay what initially seems like an “expensive” price and the investment can offer a “low” margin of safety. After some time, if the business executes well, you will realize that the “low” margin of safety wasn’t actually that low.
On the other hand, if for any reason you invest in a low-quality business, you should try to pay the lowest price possible and the investment should offer a wide margin of safety. Here, the main risk that remains is the deterioration of the business. If the business deteriorates, what seemed like an initial “cheap” price may actually be a very expensive price.
Companies with strong moats also have greater resilience, because firms that can fall back on a structural competitive advantage are more likely to recover from temporary troubles. Think about companies such as Apple, Google, Amazon, Microsoft, Mastercard, Visa, Coca-Cola, McDonald’s, Nike, Starbucks, etc. All of them are defensive businesses and temporary trouble will not make them disappear.
This resiliency of companies with moats is a huge psychological backstop for an investor who is looking to buy wonderful companies at reasonable prices because high-quality firms become good value only when something goes wrong. But if you analyze a company’s moat prior to it becoming cheap, you will have more insight into whether the firm’s troubles are temporary or terminal.
Also, moats can help you define what is called a “circle of competence.” Most investors do better if they limit their investing to an area they know well. Instead of becoming an expert in a set of industries, why not become an expert in firms with competitive advantages, regardless of what business they are in? You will limit a vast and unworkable investment universe to a smaller one composed of high-quality firms that you can understand well.
If you can see moats where others don’t, you will pay bargain prices for the great companies of tomorrow. Of equal importance, if you can recognize no-moat businesses that are being priced in the markets as if they have durable competitive advantages, you will avoid stocks with the potential to damage your portfolio.
How to Identify an Economic Moat
To determine whether or not a company has an economic moat, follow these four steps:
1. Evaluate the firm's historical profitability. Has the firm been able to generate a solid return on its assets and on shareholder equity? This is probably the most important component to identifying whether or not a company has a moat. While much about assessing a moat is qualitative, the bedrock of analyzing a company still relies on solid financial metrics.
2. Assuming that the firm has solid returns on its capital and is consistently profitable, try to identify the source of those profits. Is the source an advantage that only this company has, or is it one that other companies can easily imitate? The harder it is for a rival to imitate an advantage, the more likely the company has a barrier in its industry and a source of economic profit.
3. Estimate how long the company will be able to keep competitors at bay.
We refer to this time period as the company's competitive advantage period, and it can be as short as several months or as long as several decades. The longer the competitive advantage period, the wider the economic moat.
4. Think about the industry's competitive structure. Does it have many profitable firms or is it hypercompetitive with only a few companies scrounging for the last dollar? Highly competitive industries will likely offer less attractive profit growth over the long haul.
Moat Sources
The five major sources of competitive advantage or economic moat are the following ones:
Intangible assets: include brands, patents, or government licenses that explicitly keed competitors away. Also, companies with powerful brands can sell their products for a higher price than their competitors. This situation offers pricing power to the business which means higher profitability and higher margins overall. Some examples of wide-moat businesses with strong intangible assets are Nike, Disney, Apple, Starbucks, etc.
Cost advantage: firms that have the ability to provide goods or services at lower costs have an advantage because they can undercut their rivals on price. Alternatively, they may sell their products or services at the same prices as rivals but achieve fatter profit margins. For instance, economies of scale are a type of cost advantage. Some examples of wide-moat businesses with strong cost advantages are Amazon, Walmart, Costco, etc.
Switching costs: are those one-time inconveniences or expenses a customer incurs to change from one product to another. Customers facing high switching costs often won’t change providers unless they are offered a large improvement in either price or performance, and even then, the risk associated with making a change may still prevent switching in some industries. Some examples of wide-moat businesses with strong switching costs are Microsoft, Adobe, Shopify, Bank of America, etc.
Network effect: occurs when the value of a particular good or service increases for both new and existing users as more people use that good or service, often creating a vicious circle that allows strong companies to become even stronger. Some examples of wide-moat businesses with strong network effects are Facebook, Alphabet, Visa, Mastercard, Moody’s, PayPal, etc.
Efficient scale: describes a dynamic in which a market of limited size is effectively served by one or just a few companies. The companies involved generate economic profits, but potential competitors are discouraged from entering because doing so would result in insufficient returns for all players. Some examples of wide-moat businesses with efficient scale are pipelines businesses. Imagine there is a need to move 250,000 barrels per day of crude oil from producing basin A to refining center B, and a pipeline exists that has the capacity to move 275,000 barrels per day along this route. There is no incentive for competitors to enter.
The Bottom Line
An economic moat is the ability of a company to maintain a durable/sustainable competitive advantage over competitors in its industry or sector. It's the ability to consistently outperform other businesses over the long term, even if they are selling similar products/services.
With economic moats growing and shrinking at a much quicker rate in the modern world, it’s important to identify and understand how economic moats affect businesses.
Just because a company had a strong moat during the past doesn’t mean it will continue to be like this in the future. It’s very important to assess the durability of the moat and think about how strong it will be in the coming years.
Quoting Warren Buffet again, “No formula in finance tells you that the moat is 28 feet wide and 16 feet deep. That’s what drives the academics crazy. They can compute standard deviations and betas, but they can’t understand moats”.
Investors who analyze and understand moats have an unfair advantage over those who don’t. Valuation is important but over the long-term moats make the difference.
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Yours truly,
The Buddhist Investor
Very good read! People often want to invest in the Next Amazon, the Next Google etc. But once established, an economic moat enables wonderful businesses to generate superior returns for their shareholders for years to come. That’s why I love to focus on the well established businesses.