Making the ‘Moats’ of a competitive advantage

How can you differentiate a truly good business from one that will soon be ordinary?

December 4, 2019 | Insight

Moats

***Genova does not own, recommend or endorse any of the companies mentioned it the article***.

How would you define a “good business” in a single sentence? Most people would likely agree that a good business is one that earns a profit or, perhaps better, is one that earns a sustainable or increasing profit year after year. In a competitive marketplace, however, a business like that will attract competitors intent on getting a share of those profits for themselves. Soon our hypothetical “good business” is no better than ordinary as the competition undercuts its market share and profitability.

In searching for a good business in which to invest, how can you differentiate a truly good business from one that will soon be ordinary or worse? One indicator (popularized by Warren Buffett) is the concept of a “moat”. A moat refers to the wide ditch, often filled with water, that surrounded a medieval castle. The moat was the first line of defense from invaders for the people and treasure that lay within the castle. The bigger the moat the bigger the safeguard. In an economic sense, a moat is an attribute of a particular business that allows it to sustain its advantage over its competitors. The bigger the moat the bigger the competitive advantage.

Moats come in different shapes and sizes. A competitive advantage might be a company’s low-cost structure or its size relative to its competitors (think Costco’s ability to sell products at very low prices thanks to its economics of scale and that they benefit from annual membership fees to offset the lower margins earned on individual products). Other examples would include the high of switching for customers (think Microsoft where customers rarely switch to a different supplier), government protection via patents or licenses (such as our utility providers) or niche markets where there is only room for one dominant participant (LinkedIn for professional social media networking).

It’s not always obvious what constitutes a particular company’s economic moat but it’s a dead giveaway that there is one if the company has been able to consistently earn high returns on its invested capital over a significant period of time. It’s important to identify the moat however, in order to satisfy oneself that the competitive advantage will continue to be sustainable in future.

Buffett has emphasized that it’s not enough to just have a moat. A great business will seek to widen and deepen it. This is often accomplished with innovation particular to the industry. For example, Disney has expanded to be about more than just a mouse, now owning the Pixar, Marvel and Star Wars franchises. It owns major theme parks around the world, creates all genres of movies, TV channels and is now launching a streaming service of their family friendly movies and shows.

Of course, there is more to finding a good investment than finding a business with a wide moat. Even the best business is a poor investment if you pay too much for it. Identifying a deep and wide moat is a good place to start.