Warren Buffett (Trades, Portfolio) often talks about the importance of a business having a “moat.” Put simply, this means a definitive competitive advantage that can help the enterprise achieve above-average returns on capital.
Having a moat is one thing, but having a sustainable moat is another thing altogether.
High prices and competition
A core principle of free market economics is that high prices are a cure for high prices. This implies that high prices attract competition, which is enough to push down prices as competitors fight for market share.
We typically see this principle playing out in the commodity markets. Rising commodity prices change the economics of previously uneconomic projects, thereby justifying their construction. When the output from these projects arrives on the market, prices may fall if supply outstrips demand.
Even in the market for non-commoditized products and services, it is still hard to maintain an edge. The supercar market is a great example. Few supercar companies are as successful as Ferrari NV (RACE, Financial). Many have spent their lives being subsidized by a larger group.
There are other examples—Apple (AAPL, Financial) versus Samsung (XKRX:005930, Financial) or Coca-cola (KO, Financial) versus Pepsi (PEP, Financial). Apple and Coca-Cola have managed to build and sustain competitive advantages. Meanwhile, despite having relatively similar products, Pepsi and Samsung don’t have anywhere near the same moat.
Building a moat
There are a couple of ways a company can build a moat. It can either be bigger and more efficient, provide a better product or service or have some kind of brand power that has a special place in consumers’ minds.
Buffett explained his moat principal at the 1995 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting of shareholders:
"What we're trying to find is a business that, for one reason or another -- it can be because it's the low-cost producer in some area, it can be because it has a natural franchise because of surface capabilities, it could be because of its position in the consumers' mind, it can be because of a technological advantage, or any kind of reason at all, that it has this moat around it."
He went onto explain that the most important part of this equation was not figuring out what the moat was, but how it was still standing:
"But we are trying to figure out what is keeping -- why is that castle still standing? And what's going to keep it standing or cause it not to be standing five, 10, 20 years from now. What are the key factors? And how permanent are they? How much do they depend on the genius of the lord in the castle?"
Charlie Munger (Trades, Portfolio) has spoken about the power of inverting questions to find the right answers. It would appear that this approach is based on a similar idea.
It can be straightforward to find a business that looks as if it has a moat. Screening for companies with a high return on equity or capital employed is a good place to start.
However, these financial figures reveal almost nothing about the underlying business. This is where the work starts. The quantitative figures may show a moat exists, but investors need to understand why it exists and what, if anything, a competitor can do to bridge the moat.
Here it helps to have an understanding of the industries one is focusing on. I could not establish how a company would be able to establish a moat as a cloud computing provider, but I can understand how a moat could emerge in the insurance space. That is my edge.
If I have an idea of how difficult a moat can be to bridge, I can better understand how wide it is in the first place.
