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John Engle
John Engle
Articles (85) 

Feuding Giants: Elon Musk Attacks One of Warren Buffett’s Most Famous Investing Principles

The billionaire tech futurist thinks strategic ‘moats’ are lame

May 09, 2018 | About:

Warren Buffett (Trades, Portfolio) is, without a doubt, one of the greatest value investors of all time. Probably the greatest, though Buffett’s own Midwestern sensibilities would likely bar him from ever saying so himself.

Throughout his many decades as an investment manager, and at the helm of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B), Buffett has developed and espoused numerous principles that have since become part of the established canon of value investing. Indeed, Buffett’s many wise aphorisms and observations can stand alongside the magisterial writings of Benjamin Graham, the dean of securities analysis.

It is, therefore, rather jarring to see a high-profile business leader attack one of Buffett’s core investing principles, the idea of the strategic "moat." Yet, that is exactly what Elon Musk did last week. The renowned tech billionaire and futurist described the concept of moats as “lame” and lambasted the idea as failing to appreciate the real driver of long-term value in the modern marketplace: the pace of innovation.

Let’s take a look at this strange feud and seek to answer the question of whether the idea of a strategic moat is, indeed, outmoded or still relevant to investment strategy in the 21st century.

What is a moat?

Before delving into Musk’s assault on the idea of strategic moats, we must first explain what moats are in the value investing context. Here is how Buffett explains the moat in the context of his investment strategy:

"I want a business with a moat around it with a very valuable castle in the middle. And then I want the duke who's in charge of that castle to be honest and hard-working and able. And then I want a big moat around the castle, and that moat can be various things…

"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."

So a moat is something of a defensive structure. It is a material advantage that any potential competitor would have to overcome in order to begin assaulting the castle, i.e., the business itself. Thus, being the low-cost – or most efficient – provider of a good or service represents a moat insofar as a new entrant or incumbent competitor must act to overcome the moat by reducing their own costs. If a moat is wide and well maintained, a company can grow and generate cash flows without fear of an opponent storming their citadel.

This idea should be immediately appealing – and even intuitive – to a value-oriented investor. Value investors hunt for bargains, but also true value. That means the ability of a company to provide the investor with material gains in the form of income, capital appreciation or (ideally) both.

Musk mocks moats

Musk clearly disagrees with the value investor’s take on moats. Here is what he had to say about the concept:

“I think moats are lame. It's nice sort of quaint in a vestigial way. If your only defense against invading armies is a moat, you will not last long. What matters is the pace of innovation. That is the fundamental determinant of competitiveness.

“And for any given company, if the rate of innovation, let's say, our competitors, maybe they come up with something every six years, we're maybe every two to three years. So, if our innovation is, let's say, twice that of any given competitor, then it is simply – this is true of generally of companies in any industry. Whichever company has the highest rate of innovation, unless that company is actively killed by its competitors in some way that's nefarious, or shoots itself in the foot, it will at some point exceed those competitors.”

Musk’s seems to be saying that strategic moats are essentially static defensive structures and that this is not a source of sustained advantage. Rather, it is the company that can innovate the most rapidly that will ultimately win the marketplace.

Musk is right insofar as innovation is critical to the success of companies, especially for those operating in new and evolving technological spaces. But is it a fair assessment to call the concept of strategic moat lame or irrelevant? Buffett certainly does not think so.

Buffett pushes back

On May 5, during a lengthy question-and-answer session as part of Berkshire Hathaway’s annual meeting, Buffett was asked about Musk’s recent attack on one of his core investment principles. Visibly bemused, Buffett was quite magnanimous, opining that Musk “may turn things upside down in some areas,” but also that “being a low-cost producer is an incredibly important moat.”

Buffett went on to say that, while Musk might have an edge in some things, he would be unwise to challenge Berkshire’s candy business, See’s. Furthermore, Buffett pointed out that GEICO, a Berkshire-owned insurance company, has survived and thrived even in the presence of rapid technological innovation.

A case of misunderstanding?

Musk does not seem to understand what moats actually are. They are not physical structures, nor are they static. Fundamentally, strategic moats are not, as Musk seems to believe, quaint atavisms of a bygone age. In fact, moats continue to represent vitally important aspects of a business’ staying power, its capacity to adapt to competition and to control its own destiny.

Musk seems to misunderstand moats at their most basic level. That includes their non-static nature. To be successful in changing markets, moats need to adapt and be widened, as Buffett has pointed out on many occasions, including at Berkshire’s annual meeting in 2000:

"So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn't necessarily mean the profit will be more this year than it was last year because it won't be sometimes. However, if the moat is widened every year, the business will do very well. When we see a moat that's tenuous in any way -it's just too risky. We don't know how to evaluate that. And, therefore, we leave it alone. We think that all of our businesses - or virtually all of our businesses -- have pretty darned good moats."

Moats still matter

A bit of misrepresentation (or misunderstanding?), even by someone as respected and followed as Musk, is not going to take the sheen off of a proven fundamental investment principle. Musk’s criticisms certainly will not do much to shift investors’ perceptions of the concept. The strategic moat remains safe in the canon of value investing, and is likely to stay there for good.

Innovation matters. But moats matter too.

Disclosure: I/We own no stocks discussed in this article.

About the author:

John Engle
John Engle is President of Almington Capital - Merchant Bankers. John specializes in value and special situation strategies. He holds a Bachelor's degree in economics from Trinity College Dublin and an MBA from the University of Oxford.

Rating: 5.0/5 (6 votes)

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Comments

Soid Ahmad
Soid Ahmad premium member - 1 week ago

It's certainly a misunderstanding on Musk's part. What he's saying is basically a moat in itself. A company that has the ability to constanty innovate has innovation as its moat to protect its business concern. Some time redesigning the castle or upgrading is a part of the defence.

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