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. I have written about this in detail in What is a Moat, and how does it help an investor?
Over here, I talk with GAUTAM BAID, founder of Stellar Wealth Partners and author of The Joys of Compounding, on the subject of moats and crumbling castles. You can watch the video or read the excerpt below.
Morningstar is a strong believer in economic moats, which are competitive advantages.
You have often said that you see culture as a moat. What does that really entail? Does ethics form culture? Does innovation form culture?
We often talk about the traditional sources of competitive advantage, but a much underappreciated and difficult to replicate competitive advantage is that of corporate culture. Between 1957 and 1969, when Warren Buffett was running his private partnership, he never mentioned the word “culture” even once in his letters to investors. From 1979 to 2020, he mentioned it more than 35 times.
Culture matters to long-term investors because it empowers the company’s employees to do their daily tasks slightly better than the way their competitors do. Over time, these little advantages compound into much larger advantages which persist for far longer. It is best exemplified by companies such as Berkshire Hathaway, Constellation Software, Costco, Nebraska Furniture Mart, and Amazon.
As investors, we look for companies that are fanatically obsessed with the wellbeing of their customers and empathize with their customers more than their competitors do.
What will widen the company’s moat? Management strategy and corporate culture. For Facebook it is about improving user engagement on its various social media platforms like Facebook, Instagram and WhatsApp. For Amazon, it is all about improving the customer experience in terms of flexibility, options, convenience, speed of delivery, and making life for the customer seamless on its platform. For Nebraska Furniture Mart and Costco it’s all about sharing the economies of scale in the form of lower prices and creating good will.
When we invest in companies that are widening their moat cause of an emphasis on culture, over time, these businesses invariably turn out to be much cheaper than the results from our initial valuation work. This is how you can get an advantage, by focusing on the long-term intangible and softer aspects of businesses like the culture.
Are they difficult to narrow down on? Difficult to spot?
Not really. The best way to understand a company’s culture is to see how they focus on stakeholder value maximization. A company that focuses on all its different constituencies – employees, customers, suppliers, environment, society at large. Those that play the long-term game end up maximizing long-term shareholder value.
Shareholder value maximization is just a byproduct of the stakeholder value maximization.
You talk about emerging moats, but what about crumbling castles? A moat without a castle defeats the entire purpose.
An Emerging Moat is a company in the process of building its competitive advantage. For example, a B2B company transitioning to a B2C company with improving terms of trade. During this transition, there will be disruption in earnings, and investors who want instant gratification will dump their shares. If you have the long-term view, and are able to hold on to such companies which are in the process of building their moat, you can make handsome returns.
Crumbling Castles are very important in today’s world. They refer to companies where the primary business segment is in decline and are losing relevance with their customers. In such cases, the present moats carry little or no meaning. High market share in itself is not a moat. Think of General Motors in the U.S. In India, Maruti has the dominant market share in passenger vehicles. But, if it does not make the transition to electric vehicles, it may lose its relevance with consumers 10 years down the line. The longevity of growth, the sustainability of growth, is becoming increasingly scarce in today’s world characterized by rapid pace of change.
In 1969, the average time a company spent in the S&P 500 was around 60 years. Today the average age of a S&P constituent is just 10 years. If you were on the Fortune 500 list in 1955, in 2020 it would reveal that more than 90% of them would either be bankrupt or acquired by some other companies or fallen off the list as ranked by total revenue. The moats in such cases are illusionary.
So buy-and-hold should not be buy-and-forget.
Never.
Exercise active patience. Diligently verify your original investment thesis all the time. Proactively look out for disconfirming evidence. Do nothing till something materially adverse emerges.
Watch the above interaction on video