Warren Buffett (Trades, Portfolio) has famously proclaimed time and again that when he is looking for a business, the companies he seeks out have broad and deep economic moats, moats that cannot be breached easily by competitors. Even though Buffett has never sat down and accurately described how he goes about searching for a moat and the characteristics he is looking for (there may be no definitive answer), it is widely believed he is looking for an advantageous competitive advantage, a competitive edge that no matter how much money a new entrant to the market has, they cannot take on the existing business.
Buffett explained this concept to a group of MBA students at the University of Florida in 2007:
“The moat in a business like our auto insurance business at GEICO is low cost. I mean people have to buy auto insurance, so everybody’s going to have one auto insurance policy per car basically, or per driver. And…I can’t sell them 20…but they have to buy one. What are they going to buy it on? They’re going to buy it based on service and cost. Most people will assume the service is fairly identical among companies, or close enough, so they’re going to do it on cost, so I gotta be the low-cost producer. That’s my moat. To the extent my costs get further lower than the other guy, I’ve thrown a couple of sharks into the moat.”
But just having a moat is not enough as sooner or later, competitors will realize the opportunity on offer and try to invade your market:
“But all the time, if you’ve got a wonderful castle, there are people out there who are going to try and attack it, and take it away from you. And I want a castle that I can understand, but I want a castle with a moat around it.”
Case and point is Eastman Kodak Co.Ă‚ (KODK, Financial) (at the time of the lecture, the company was starting to crumble but had not yet folded):
“Thirty years ago, Eastman Kodak’s moat was just as wide as Coca-Cola’s (KO, Financial) moat. I mean if you were going to take a picture of your six-month-old baby, and you’re going to want to look at that picture 20 years from now, and you’re going to want to look at it 50 years from now. And you’re never going to get a chance — I mean you’re not a professional photographer — so that you can evaluate what’s going to look good 20 or 50 years from now. What is in your mind about that…photography company is what counts because they are promising you that the picture you take today is going to be terrific to look at 20 or 30 or 50 years from now about something that’s very important to you. Maybe your young child or whatever it may be. Well, Kodak had that in spades, 30 years ago, they owned that. They had what I call share of mind. Forget about share of market – share of mind. They had something in everybody’s mind around the country, around the world – the little yellow box and everything – that said, 'Kodak is the best.' That’s priceless.”
Kodak had a moat, but it was not prepared to invest to protect it. The company’s competitors came knocking, and aggressive marketing helped wear away the moat:
“They’ve [Kodak] lost some of that. They haven’t lost it all…but they let that moat narrow. They let Fuji (FUJIF, Financial) come and start narrowing the moat in various ways. They let them get into the Olympics and take away that special aspect that only Kodak was fit to photograph the Olympics. So Fuji gets there and immediately in people’s minds Fuji becomes more on a parity with Kodak. You haven’t seen that with Coke. Coke’s moat is wider now than it was 30 years ago. You can’t see the moat day by day, but every time…the infrastructure gets built in some country that isn’t yet profitable for Coke but will be 20 years from now, the moat is widening a little bit. Things are all the time changing that moat in one direction or another. Ten years from now you can see the difference. Our managers of the businesses we run, I’ve got one message to them, which is to widen the moat. And we want to throw crocodiles and sharks and everything else, gators, I guess, into the moat to keep away competitors. And that comes about through service, it comes about through quality of product, it comes about through cost, it comes about sometimes through patents, it comes about through real estate location.”
There are fundamental factors also to consider. For example, Coca-Cola is a high return, high margin business. The company can afford to spend billions on marketing and developing new factories around the world to increase its margins. Other companies might not be so lucky. Companies that have low margins and high capital spending requirements will never be able to maintain the same kind of moat. Further, poor capital allocation decisions by management may result in the business underinvesting and undermarketing, impacting the defense of the moat (possibly the mistake IBM (IBM, Financial) made by returning too much money to shareholders and not investing enough in its own brand).
Disclosure:Ă‚ The author owns no stock mentioned.
