A moat is a deep and broad ditch filled with water that acts as a line of defence to a castle. In other words, it keeps invaders out.
Warren Buffett popularised the term economic moat. He looks for “economic castles protected by unbreachable moats”. The castle being a metaphor for a company, and the moat being a durable competitive advantage it possesses.
Let’s say a firm is generating high profits. Naturally, this would result in competition because capital flows to the areas of highest potential return. High profits attract competition and competition reduces profitability. The firms that stay profitable for a long time manage to do so by creating economic moats.
An economic moat is a structural business characteristic that allows a firm to generate high returns on capital for an extended period. It acts as a barrier that protects a company from competition.
Moats are just a metaphor for the superiorities a company possesses that make life difficult for its competitors.
Companies can build moats in a variety of ways - strengthening the brand name, achieving economies of scale, lobbying for special status from the government, network effects, data, and repeat engagement within a product ecosystem.
Google started its moat by developing a better algorithm for indexing and searching the internet. The company has since strengthened that moat by putting that advantage to work in transportation, shopping, and advertising.
Coca-Cola built and strengthened its moat by deepening the thought in people’s minds that Coca-Cola is where happiness is. The moat is what’s in your mind. Coca-Cola is associated with people being happy around the world. Happiness and Coke go together.
According to CBS Insights, Amazon’s dominance has been built on a variety of moats. But early on it recognised that the more people in its network — both suppliers and customers — the lower the prices it could offer to buyers. Lower prices meant a better customer experience that attracted more customers; more customers attracted more sellers; more sellers meant a better selection of goods and prices; better goods and prices created a better customer experience; and so on. “I want to draw a moat around our best customers. We’re not going to take our best customers for granted,” Bezos said while Amazon was planning Prime.”
How Buffett bet on the moat of Amex.
Allied Crude Vegetable Oil was a company owned by small-time businessman Tino De Angelis. He would borrow money from a bank via a line of credit, buy shiploads of vegetable oil and store it in container ships, sell the oil and then pay back the line of credit.
The oil in the tanks was inspected regularly and pledged as collateral for the line of credit. De Angelis ingeniously thought of a way to outsmart the banks. He would fill the containers with water and had only a few feet of salad oil on top. Since the oil floated on top of the water, it appeared to inspectors that these ships were loaded with oil. Meanwhile, De Angelis used this as collateral for taking more credit.
American Express provided credit to the company based upon the inventory of the company’s soybean-based salad oil.
In Trade like Warren Buffett, James Altucher claims that De Angelis obtained $175 million in financing on the basis of $60 million worth of vegetable oil as collateral. He used the money to speculate on vegetable oil futures (where he eventually lost all the money). In 1963, the entire operation blew up when it was discovered that the company could not account for the absence of more than $175 million in salad oil.
When Amex did an audit to recover their collateral, they discovered that instead of $60 million worth of oil, there was just $6 million. This con job, dubbed as the “Salad Oil Scandal”, resulted in Amex losing nearly $58 million.
Though Amex instantly made good on the hundreds of millions of dollars in potential liabilities, there were fears that the company would go bankrupt. Investors panicked. As Wall Street bailed for the exits, Amex shares dropped from $60 to $35 over 60 days.
But 33-year old Buffet believed that the market was wrong, and that fears over the eventual liability were overblown.
- He was impressed by Amex's instant response to the losses, taking the hit and indemnifying many of the third-party victims.
- His calculations showed that the cash-flow generating capabilities were intact.
- He recognised that this scandal had nothing to do with Amex's core businesses - credit cards and travellers cheques, in which the company was a distinct market leader with excellent brand recognition.
- Amex’s competitive advantage was untouched.
- To ensure that he got a feel of what was happening on the ground, he spent some time with the cashier at Ross's Steak House in Omaha. He noted that the scandal did not stop people from using their green cards.
Buffett believed in Amex’s moat - the strength of its brand name, the customers that aspire to be associated with the brand, and the stickiness of the customer relationship with the company. He knew that Amex's intangible qualities (trust and reliability) were intact. His confidence was based on his inference that the Amex brand was still strong along with the underlying business, and the scandal was just a one-time hit against earnings.
According to his 1994 shareholder letter, he bought 5% of the company for $13 million. He put about 40% of Buffett Partnership Ltd.'s capital into the stock - the largest investment the partnership had ever made. He also noted that Amex earned $12.5 million in 1964 and $1.4 billion in 1994. According to Business Insider, Amex is one of the five biggest positions in Berkshire's portfolio. Berkshire Hathaway is the company's largest shareholder. It owns 152 million shares of Amex, giving it a 19% stake.
Nothing lasts forever.
Remember Nokia? Eastman Kodak? Palm, which pioneered the personal digital assistant?
In the late 1990s, the Palm Pilot became an exceptionally popular organizational gadget, and investors quickly caught on to this trend by bidding up Palm's market value to around $30 billion in the fall of 2000. Rivals (Handspring, Sony, Hewlett-Packard) introduced their own versions cannibalizing market share from Palm and eroding its margins. By 2003, Palm's market cap stood at around $350 million. Although Palm had built an impressive castle, it couldn't build a sufficient moat to defend that castle from its rivals.
That’s why investors should look for firms that have a sustainable competitive advantage--not just an interesting new product, but a unique asset that can truly stand the test of time.
Larissa Fernand is Senior Editor at Morningstar India. You can follow her on Twitter.
