A moat is a deep, broad ditch, either dry or filled with water, that surrounds a castle, fortification, building or town, historically to provide it with a preliminary line of defense. The 13th-century Caerlaverock Castle in southern Scotland is a fine example.
What is an ‘economic moat’?
Warren Buffett popularized this concept using the visual imagery of moat around a castle. Think of the business as the castle and the moat is nothing but the competitive advantage the business enjoys over its competition.
The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors. – Warren Buffett
Note that there are two key elements which Buffett looks for.
- Wide moats
- Sustainable moats
The most important thing to me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles. – Warren Buffett
We are now at the 6th stage of our Investment Research Process- Analyzing Moats. It will be useful to review the Environment Analysis we did earlier, especially the Porters 5 forces analysis.
One of the basic truths about economics is that, over time, competition will erode away any competitive advantage enjoyed by a firm.
If one company is making excess returns in a particular product or service, it will not take long for other companies to take notice and enter the field and force the profit margins to come down. Unless the the incumbent company can come up with a strategy to continually protect its competitive advantage, over time, the excess return will come down to match the opportunity cost.
There are examples of companies who enjoyed a durable competitive advantage over long periods. Anyone who invested in those companies for a long time amassed a huge amount of wealth.
While it is easy to identify companies which enjoyed sustainable moats in the past (everything is clearer in hindsight), it is not easy to identify moat or even the sustainability of moat in future.
Luckily, there are some helpful pointers.
First of all, let us look at the types and sources of moats.
‘Barriers to entry’ (or moats) can be classified as structural or strategic according to Prof. Alex Scott as described in his book Strategic Planning. Given below is an abridged explanation from the book:
Structural barriers are outside the control of the firm while strategic barriers depend on actions undertaken by the firm that deter entry.
Structural barriers include:
- Size of the market: because of investment and infrastructure costs it may not be feasible for more than one company to operate in the industry. A well-known example is electricity generation and supply, where duplication of electricity lines would clearly be wasteful.
- Capital requirements: it is typically necessary to undertake significant investment expenditure in order to enter a new market, and some industries require amounts which can be difficult to raise unless the company already has a secure track record; the capital requirement itself can pose a major threat to the entrant should the enterprise fail and the investment costs cannot be recovered.
- Sunk costs: it is not only the costs of entry which are important, but the costs of exit. At first it might seem a paradox, but in fact the barrier to exit is just as important as the barrier to entry. Consider the case of an airline: it costs a great deal to obtain an aero-plane and set up a route. The route set-up costs are sunk because they cannot be recovered on exit; this is the real financial barrier to entry.
- Control by legislation or tacit agreement: examples are government support received by certain businesses, legal protection over design provided by patents, or tacit agreement between a few players (example OPEC countries)
- Economies of scale: The idea of economies of scale is based on the long run average cost curve of the firm, as shown below: If the existing firm is well down the long run average cost curve, it is clear that new entrants have to come in at a large scale otherwise they will be at a significant cost disadvantage.
- Experience effect: reductions in unit cost occur as the labour force learns by doing, more effective practices are adopted, materials wastage is reduced and so on; but it becomes progressively difficult to achieve experience gains and after some time there are no further benefits at the margin. If the experience effect is significant it will convey a significant first mover advantage to the incumbent firms in an industry, and new entrants start off at a cost disadvantage.
Strategic barriers arise from competitive actions undertaken by the company, and include:
- Reputation: the company can aim at building up a high degree of brand loyalty by emphasizing characteristics such as quality and reliability; this is particularly important in industries where it is difficult for consumers to obtain comparable information on different products, for example products which are purchased only rarely like expensive white goods.
- Pricing: when the threat of entry emerges the company can reduce prices (or keep the prices low) as a deterrent but this can really only work where the company is either a monopolist or it enjoys significant cost advantages due to structural barriers.
- Access to distribution channels: while the new entrant may have a product which compares in quality and cost to the incumbent’s, this can be of little avail if the incumbent controls distribution.
‘Soft power’ moats
Some of the reasons for economic moats are difficult to identify but are still vital.
- A unique leadership : think of Steve Jobs & Apple, Elon Musk & Tesla and you see the point about unique leadership.
- A unique corporate culture : Google is an example where the company’s unique innovative corporate culture is a contributor to its success.
Now, how to analyse moat through numbers?
The characteristics of competitive advantage will surely reflect on the results numbers and balance sheet over time. Look for evidence of the presence (or lack) of moat by checking the below.
- Sustained revenue growth over long periods
- High Return on Equity (RoE) over long periods
- Growing Free Cash Flow (FCF) over the years
- Quality of balance sheet over the years (reducing debt, growth through internal accruals)
Also a very low profit margin when accompanied with an efficient operation with high RoE can be good source of moat. This rather un-intuitive point was wonderfully explained by Prof Sanjay Bakshi in his Relaxo Lecture)
You can check these easily using online tools such as Screener or by going through the annual reports and financial statements and doing some simple calculations.
Examples (screenshots from www.screener.in):
See the consolidated Sales growth Profit growth and Return on Equity of three companies below. (Warning: I am not recommending any of them at the current price. I hold Kitex.)
What do you see in common among all three companies above? All three have very good Return on Equity. All three manage better profit growth than sales growth over long term (indicating consistent efficiency improvements).
Do you see evidence of sustained competitive advantage in these companies?