Picture this, if you will. You’re in medieval Europe (stay with me). Your king places you in charge of building a fortified castle in the hinterlands. Invaders will attack at some point – it’s just a question of when.
How do you go about building this castle?
Ideally, you’d set the castle on high ground, build thick walls with rounded turrets, and so on. Another standard defense would be to place a moat filled with water around the walls to serve as a siege deterrent.
Once established, you might even feel quite secure behind your moat. Whether it’s due to time or technology, however, a moat eventually loses its defensive value. An attacker could slowly fill the moat with dirt or discover the canon to destroy your walls from a distance. When that disruption happens, you’ll either need to develop new defense tactics or surrender your position.
A moat buys you time – nothing more, nothing less.
It’s much the same with an “economic moat” – a term coined by Warren Buffett to describe a structural advantage that enables a company to consistently defend its competitive position. Economic moats can be extraordinarily valuable to a company and allow it to generate high returns on invested capital (ROIC) for a decade or more, creating immense shareholder value in the process.
The source of these moats can vary by company and sector. To illustrate:
- Facebook benefits from a “network effect” advantage. Its network grows stronger and more valuable with every new user and interaction on the site.
- Coca-Cola’s portfolio of brands creates a strong intangible asset advantage. Consumers are willing to pay more for a Coke, for example, than they are a store brand version of an almost identical product.
- Apple created such a seamless ecosystem between iTunes, iPhone, and iPad that once you’re in that system, it is costly – either in time or money – to switch to a competitor’s products. Because these costs often outweigh the benefits of changing providers, Apple benefits from a “switching cost” advantage.
Like a medieval moat, all economic moats eventually deteriorate and lose their defensive value. It’s just a question of when it happens and how the company adapts to that change.
Why look for moats?
The market typically assumes a company with high ROIC will revert to its cost of capital within the next ten years. In other words, the market expects that once competitors figure out how to attack, they will destroy any existing competitive advantage a company had.
(I’ve tried my hand at illustrating this process – please pardon the “back of the envelope” drawing.)
And in most cases, the market is correct to assume advantages are more temporary than durable. We see this with companies who enjoy a short-term edge (GoPro, Crocs, etc.) only to see competition quickly step in and wipe out once-robust profit margins and ROIC.
Companies with economic moats, however, can sustain high ROIC for longer periods of time. This phenomenon forces investors to re-inflate their expectations, making the identification of an economic moat a valuable endeavor for the long-term investor.
With the benefit of hindsight, it’s easy to identify companies that have delivered high returns for a generation or more. Their moats seem obvious now.
What we care about, however, is what happens next. Due to rapid innovation and globalization, it is harder to be confident in a company’s economic moat. No company or industry is immune to these challenges. And while these effects may benefit us as consumers (more choices, lower prices), as investors there’s higher uncertainty surrounding individual company prospects.
According to the consulting group Innosight, for instance, the average lifespan of a company in the S&P 500 index fell from 61 years in 1958 to just 18 years in 2011. Think about companies like Uber, which didn’t exist ten years ago and has since disrupted the traditional taxi and car-for-hire industry. Similarly, Airbnb was founded in 2008 and has altered the way consumers think about lodging on vacation and business trips.
Amazon founder and CEO Jeff Bezos once famously quipped, “Your profit margin is my opportunity.” Judging by Amazon’s push into the retail, apparel, distribution, and technology businesses, it’s clear that Bezos wasn’t joking around. If an upstart competitor can deliver a better product at a similar price or a similar product at a better price, it can quickly diminish an economic moat. An example of this is how Dollar Shave Club, which was acquired by Unilever in 2016, changed the dynamics of the men’s razor market (dominated by Gillette and Schick) by offering comparable disposable blades at a deep discount via a direct-to-customer model.
What to do?
This era of disruption doesn’t mean that analyzing economic moats is now pointless. Quite the contrary. If the market increasingly assumes disruption is just around the corner for companies, but you think you have a knack for identifying firms with defensible economic moats, you have an opportunity to realize strong returns.
So, how might we get started in this quest? Here are a few questions you can ask before making your next investment:
- Does new technology help or threaten the company’s business model?
- What is this company doing now that its competitors aren’t doing yet?
- If you had $100 million in capital, what would stop you from entering this market and doing so profitably?
- Is the company adequately addressing its consumers’ most pressing needs?
- Does the company’s corporate culture help or hinder its ability to respond to change?
It’s more important than ever for investors to pay attention to competitive or disruptive threats to the businesses they own. The days of buy-and-forget, if they ever existed, are long gone.
Stay patient, stay focused.
You can also follow Johnson Investment counsel on Twitter @johnsoninv
Todd Wenning is a Research Analyst with Johnson Investment Counsel (“Johnson”). Todd’s household and some clients of Johnson own shares of Amazon.
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