When considering a company's investment potential, according to Warren Buffett (Trades, Portfolio), it is critical to determine whether it has "a moat around it with a very valuable castle in the middle." While such a moat can take different forms, its function is the same: protecting the company from competitive threats.
Charlie Munger (Trades, Portfolio), Buffett's long-time business partner, has also long been an evangelist for economic moats. They have spent decades filling Berkshire Hathaway (BRK.A) (BRK.B) with such competitively blessed companies.
Yet while moats can be powerful, they are not unassailable. The key for investors, according to Munger, is to be able to differentiate companies with ephemeral competitive advantages from those with true structural economic moats.
Old moats disappear
History is awash with examples of companies that once dominated their markets only to see their market leadership stripped away by competition or industry changes. Speaking at the Daily Journal Corp. (DJCO) annual meeting in February, Munger observed that the pressure on companies' moats has intensified:
"Moats have been breached time after time. Imagine the Eastman Chemical Company going broke. Imagine all these great department stores being on the edge of extinction. Imagine all those monopoly newspapers going down. Look at the strength of the American auto industry compared to what it was, say in 1950. I think the moats are disappearing rapidly. I mean the old classical moats. I think it's probably a natural part of the modern economic system, as in old moats stop working."
As the pace of technological change has accelerated in recent years, so too has the pressure on incumbents across a multitude of industries. Companies such as Amazon.com Inc. (AMZN) have managed to disrupt not just one, but many industries. In the face of such pressures, many incumbents have seen their moats shrink, or even disappear altogether.
Avoiding change, not conquering it
The pace of technological change and industry disruption may have intensified in many cases, but some sectors are shielded from such disruption thanks to their fundamental industry economics. Munger focused on this idea during a virtual public appearance at the California Institute of Technology earlier this month:
"Berkshire owns the Burlington Northern railroad. You can hardly think of a more old-fashioned business than a railroad business. It's an excellent asset. Who is going to create another trunk railroad? We made that a success, not by conquering change but by avoiding it. It helps to have a position that almost can't be taken away by technology. How else will you haul goods across the land, from Los Angeles to Chicago?"
Berkshire's success with leading railroad companies is illustrative of the power of moats in industries that are naturally resilient to disruption. Rather than being forced to contend with change, such industries can simply avoid it altogether. That can prove to be a powerful advantage in an economic environment otherwise buffeted by waves of disruption.
Moats still matter
While many companies have seen their economic moats come under threat in recent years, moats still matter. The trick is to identify companies with resilient moats in industries that are difficult, or even virtually impossible, to erode. That requires doing more than simply looking at historical financial performance, as Gary Mishuris of Silver Ring Value Partners, a long-term value-oriented investment firm, explained:
"It's even more important than usual to not practice 'blind' value investing. In blind value investing, an investor just looks backwards at the financial history, assumes that something similar will occur in the future, and considers a company a bargain if it's cheap relative to historical profits. That is still a good place to start, but a lot more judgement needs to be exercised to guard against adverse fundamental changes to the business."
In my view, economic moats still represent one of the most potent weapons of high-quality companies. But finding such companies, much like finding bargains in the current superheated stock market, is getting harder.
Disclosure: No positions.
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