Successful investments over the long-term depends very much on simply identifying and buying great businesses. A moat is a structural feature allowing a firm to sustain excess profits over a long-term. Moats can take on many forms and are sometimes referred to as the mythical creature of investing. Some investors see signs of a moat everywhere but for some other investors, identifying a moat seems just out of reach.
This term is attributed to Warren Buffett. If Buffett cares about moats, perhaps we should do the same too! A moat is a sustainable competitive advantage. The imaginary moat is a body of water that protects a castle and aptly, a moat protects a company from competition. To offer effective protection, the moat must be sustainable. A company may benefit from a first mover advantage but without the protection of a moat, those advantages will be eroded over time by competitors eager to get a piece of an attractive opportunity. Ideally, a company should have a sustainable competitive advantage of 10 – 20 years.
To be a great investor is to be a student of business. We are evaluating businesses when we consider which share to buy. Once we have purchased a share, we are an owner of a business. Any evaluation of a business start with the environment the company operates within.
For most of the world that environment is capitalism. Capitalism is synonymous with competition. When it is functioning correctly, competition benefits consumers. Companies invest in creating better products and services for us to buy and they compete on price so that we get better deals. Not so long ago, Uber and Grab competed head-on and consumers benefited from their price war!
The problem is that competition isn’t great for companies. It means spending more money on research and development and marketing! It also means eroding profit margins as prices on goods and services are cut. The combination of that spending and lower prices means lower profits.
We can see the impact of competition in the financial statements of companies. A company funds itself using loans from banks, by issuing debt and by selling shares. This funding has a cost and when it is investing in growing the business, it earns a return. If that return is below the cost, eventually the company would go bankrupt. If the return is higher than the cost of capital, the company thrives over the long-term.
These outlier scenarios are rare. Over the long-term, most companies find their cost of capital and the return achieved from investing that capital roughly even. This is the impact of competition eroding returns and the fact that a company is a self-perpetuating entity that will constantly keep struggling to grow.
Earnings returns that match the cost of capital is not a great outcome for investors. However, the company can keep growing and keep paying management and employees as long as enough discipline is maintained to not let the return on invested capital dip below the cost of capital.
To find a great business, one has to find one that earns higher internal returns than competitors in the same industry. A business that keeps more of their revenue through higher margins, that is the pathway for compounding returns over decades.
How to identify a moat? There is no magical formula. In retrospect, we can see companies that earn higher margins and higher returns on invested capital. That is the past but what matters is what happens in the future.
To find a moat, answer these questions…:
- Start thinking of a product or service that you, your family and friends regularly use. Think about what influences your purchasing decision and cause you to buy a competing product or service. Would you switch to a competitor if there is a slightly lower price? If the answer is yes, that means there likely isn’t a moat.
- Is this a product or service where new innovations are constantly causing you to switch to a better offering until something better comes along? If yes, there likely isn’t a moat
- Does the product or service become more valuable to you because more people use it? If it does not become valuable, there likely isn’t a moat.
- Think about what it takes to deliver that product and service. What influences the cost of providing that good or service? Are their efficiencies available to companies with larger scale?
- Barrier of entry – Is there anything that prevents or inhibits new competitors entering the industry and providing new goods and services that you might consider buying?
Here are some of the moat sources:
- Network effect – occurs when the value of a company’s goods or services increase for both new and existing users as more people use them. Network effect is often found in technology enabled services such as social media, payment platforms, communication platforms and e-commerce. The more connections available, the more value a user derives from the service.
- Intangible assets – Patents, brands, regulatory licenses and other intangible assets can prevent competitors from duplicating a company’s products or allow the company to charge higher prices.
- Cost advantage – firms with a structural cost advantage can either undercut competitors on price while earning similar margins or they can charge market-level prices while earning relatively high margins. In general, cost advantages stem from scale from firms that can spread their fixed costs over high customer bases.
- Switching cost – when it would be too expensive or troublesome to stop using a company’s products or services, that indicates pricing power. For commonly purchased items, competing products may simply be a shelf away. For some goods and services, it requires significant effort like switching a bank account or changing software that is embedded within a personal or business process.
- Efficient scale – a niche market is effectively served by one or a handful of companies, efficient scale may be present because it is not worth it for competitors to enter the market given the small number of customers.
Example of a moat – the banking industry. The industry benefits from scale as the fixed costs of branches and technology systems can be spread more efficiently across large customer bases. Their size also allows them to access funding at advantageous rates. Banking products also have high switching costs. Customers typically utilise multiple services by banks including various accounts and credit products. Direct deposit and bill pay services intertwine banking within the customer’s daily life. We can see the impact when we compare the financial statements of the large, dominant banks and mid-sized banks.
Although it may not be readily apparent on how to identify a moat, there is nothing stopping any investor from learning the signs. The more we think about the underlying business we are buying and its competitive forces, the better we become at investing.
Buying companies with moats is a long-term strategy. A company earning higher returns than the cost of capital and keeping more of each cent of sales that competitors will accrue to investors over time. Over decades, these incremental differences matter and that is what makes a company great.
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