Digging deeper into the Moat
The core of Buffett’s philosophy is buying companies with a strong competitive advantage or how he calls it: A moat.
Here’s a deeper look at moats, the different competitive advantages that companies can have and ways to confirm them.
Investing is about generating a sustainable rate of return over the long term: Being able to grow your savings at least at a higher rate than inflation. Gambling is never a good long-term strategy. You want to invest your savings in a well protected business, a business that will still exist when you decide to withdraw your funds. A moat is the wall that protects this business.
Some moats are easy to spot: Take for example Walmart. Due to decades of recurrent investments Walmart became one of the largest companies in the world. With its economy of scale, it is able to be the low price retail store. No competitor can offer what WALL-Mart has: this is its moat.
One of the best ways to determine companies with a competitive advantage is to examine their pricing power. A company that is able to increase its prices without sweating is sure to have a moat. Furthermore, being able to have a stable or growing market share is a clear example of a company with a moat. Examples of industries with stable market share are Pharmaceutical, Beverages, and Rating Agencies.
Let’s dig deeper into Walmart’s moat:
As I explained previously, a moat is a wall which protects a company. Walmart has built its moat over decades. It is now the low price retail king with more than 8500 stores. Due to its large size and economies of scale, this mega company can offer lower prices than its competitors. It can increase its prices and still have lower prices than any other retail store.
Few competitors will venture into a duel with the giant retailer. The fact is that due to its proximity, production scale and reputation for lowest prices, Walmart has an impenetrable moat. You can be sure that in 50 years it will still be the low price place to go.
Other types of competitive advantages include government contracts, licenses, patents and even sometimes extraordinary managers like Steve Jobs or Elon Musk (however this is only a temporary moat).
On another note, learning curves (the efficiency gained through experience), advertising Investments, and R&D/patents strategies—create high entry costs. As for reputation, limited pricing set by monopolies and excess capacity which leads to low prices— they influence the profitability of new entrants.
From a financial point of view, companies with strong competitive advantages have high ROIC, ROE and Return on tangible assets. They usually also have high margins due to their pricing power and efficiency. The lower their expenditure needs, the more free cash flow they have to allocate to dividends and share repurchase.
Here are strategies used by companies to achieve competitive advantage (Source: Gaining a sustainable competitive advantage by Jay Barney).
For a fragmented industry: consolidation by discovering new economies of scale or altering ownership structure.
For an emerging industry: first mover advantage, technological leadership, preemption of strategically valuable assets, and creation of customer switching costs
For a mature Industry: Product refinement, investment in service quality, process innovation.
In a declining industry: leadership strategy, niche strategy, harvest strategy, divestment strategy.
International industry: multinational opportunities, global opportunities, transnational opportunities.
Network industry: first mover advantage, winner takes all strategies.
Hypercompetitive Industry: flexibility, proactive disruption.
Finding companies with a moat is no easy task, it takes time and research. You must be willing to read anything and everything, pick up the phone, call companies, employees and visit the store… But if you’re willing to do the job, the rewards are as much educational as they are financial.