Moats are in the news! Economic moats, that is. Who would’ve thought? Buffett/Munger (representing Berkshire) and Musk (from Tesla) had a little back and forth about the importance of a moat.
Buffett: “So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business…When we see a moat that’s tenuous in any way -it’s just too risky. We don’t know how to evaluate that. And, therefore, we leave it alone. “
Musk: “First of all, I think moats are lame. They’re like nice in a sort of quaint, vestigial way. But if your only defense against invading armies is a moat, you will not last long. What matters is the pace of innovation. That is the fundamental determinant of competitiveness.”
Munger: “Elon says a conventional moat is quaint, and that’s true of a puddle of water.”It’s ridiculous. Warren does not intend to build an actual moat. Even though they’re quaint.
Buffett: “I don’t think he’d want to take us on in candy.”
Musk: “Then I’m going to build a moat & fill it w candy. Warren B will not be able to resist investing! Berkshire Hathaway kryptonite …”
This exchange between the billionaires made me think about economic moats. Do they matter? How do we now that a company has a moat? Do companies with a moat outperform companies without a moat?
What is Moat?
Warren Buffett in one of the interviews defined the moat as follows:
“… when you have a wonderful business, it’s like having an economic castle. The nature of capitalism is that people want to come in and take your castle.
…What you need is a castle that has some durable competitive advantage. A castle that has a moat around it. And one of the best moats is to be a low cost producer. But it can be other things like the ability to produce great motion pictures.
…We are looking for that, institutionalized. We are looking for an institution that regardless of the person in charge will maintain that competitive advantage over the decades.”
You want a moat that will protect the business from competition. You want a moat that is inherent to the business and one which is sustainable for a long period of time. But if a company becomes more profitable there will be more competitors out there trying to emulate the success of that company and gain a peace of its market share. This is why a moat can narrow over time. Look at Nokia, for instance. When Apple brought the iPhone on the market, Nokia’s sales dropped considerably and its moat was eroding. To stay on the top a company needs constantly widen its moat, it needs to consistently generate high returns on capital.
Buying a wide-moat-business at a fair price or at a discount can be advantageous to the investor in the long run. Wide moat companies have lower risk and they tend to increase their intrinsic value over time. The downside is that you have to be patient.
5 Ways to Determine if a Company has a Moat
Morningstar developed these criteria to judge if a company has a moat:
- Intangible Assets
- Customer Switching Costs
- Cost Advantage
- Network Effect
- Efficient Scale
1 Intangible Assets
Here you can think of brands, patents or government licenses. If a company has a strong brand name it can charge customers more for its products. Now, not all the known brand names have a pricing power. You may well know American Airlines or KLM but I don’t think that you would pay more for a ticket just because it’s KLM. It is different with Tiffany or Coca Cola. People are willing to pay more for a Tiffany diamond ring than for any other. The same goes for Coke. People are drinking Coke for over a 100 years. Its customers developed taste for Coke and they are loyal to its brand. They trust it. Of course not all brands will turn out to be profitable. Some brands are juts a hype. Its popularity is just seasonal or it’s fashionable at a particular time. Here you can think of Crocs (maker of casual shoes and sandals). You have to be on the lookout for a company that invests in research and development and marketing to make its brand strong. Just look at Walt Disney or McDonald’s. Those companies became embedded in our life. Every child knows those two companies, even before the age of three.
2. Customer Switching Cost
This is a one time expense a customer needs to incur if he wants to switch from one product to another. You have to ask yourself: how high are the cost of switching and what are the benefits and how long would the adjustment period take. Here you can think of Microsoft’s Windows Operating System. If you are a business, then switching to another OS and training personnel would come at a high price.
Banks have switching costs too. Just imagine a competing bank would offer you a cheaper account than your current bank. Would you be willing to switch accounts, and go through the hassle of notifying every institution (phone, water, energy company etc.) that needs your new account, just so save a few bucks?
3. Cost Advantage
There are some factors that can contribute to having a cost advantage, such as: better location, process advantage, access to a unique asset (gold, oil, dump), or scale. Moats relying on a cost advantage can be powerful when sustainable. A company that has cost advantages in the form of scale advantage can easily undercut its competitors by lowering its costs or price. Amazon, Walmart and railroads are some of the examples with high cost advantages.
4. Network Effect
Network effect takes place when a value of a particular service or a product increases with its popularity as more and more people start using it. You don’t have to think hard to think of an example. Facebook has a network moat. A lot of people use Facebook. The more people use it, the bigger its moat becomes. And Facebook found a way to monetize the network through advertisement. Other examples are eBay and Yahoo Japan.
The problem when you want to compete with a company that has a network moat is that you need to get a huge amount of users to switch to your service. Think about starting an auction site to compete with eBay. When you only have 100 users on there, they are better of using eBay than your site. Same with a social media site.
5. Efficient Scale
When the market is limited for new entrants there can exist an efficient scale advantage. You can think of a hospital or airport. Usually a city only has one, making that one the natural monopolist.
When efficient scale is low, a lot of companies can enter the market and they can all profit from it (retail market). If efficient scale is high the opposite is true. Only a handful of companies (sometimes just one) can enter the market and be profitable. A new entrant usually needs a lot of capital to enter this market. To cover his costs, he would have to capture a big portion of the market. But with the limited market it is not possible. Apart from hospitals or airports you might think of gas, pipeline, water, and electricity companies.
Do Moat-Companies outperform the Market?
Morningstar did set up a Wide Moat Index. It has around 40 companies in it that enjoy competitive advantage. Investing based on moats may be a smart idea in the long run. Since its inception it outperformed the S&P 500 Index. Investing in undervalued moat companies gives you margin of safety and better long term return. But don’t focus on moats alone when investing. It should be one of your tools in evaluating a company.
Is Musk right? Is Innovation enough
Sadly, innovation is not enough. If a company has no moat and its only weapon to fend of competition is innovation it will loose the battle and eventually its market share. The truth is that other bigger and more efficient companies can copy your formula and step on your toes. No matter how much a company will spend on research and development then. But out-innovating the competitors will be virtually impossible. A good example is Snap. It has spent 45% of its revenue on R&D. In comparison, Facebook, its bigger competitor, spent only 21.4% of its revenue on R&D and Google just 15.5 %. Snapchat may be an innovative company with cool apps but their castle stands open for invasion, with no moat around it. It’s easy to leave Snap, but it’s difficult to leave Facebook. It’s the to-go social media app.
By the way, Buffet’s Berkshire Hathaway has returned ca. 20% annually to investors over the years and is one of the 5 largest companies in the US. Tesla has yet to turn a profit (yes, I know, next quarter they will [again] finally turn a profit).
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Some Further Reading: