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Beyond the Numbers

Beyond the Numbers

Trusted advice to help you think big and plan bigger.

What Is and Isn’t a Moat

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Research Analyst
Research, Cincinnati

As a sports fan, I’m in awe of franchises that are consistent contenders for league championships.

The New England Patriots are a case in point. Players come and go each season, but they are always in playoff discussions. And this isn’t hyperbole – in each season since 2001, the Patriots finished in 1st or 2nd place in their division. Oh, and they also won five Super Bowls.

All this despite the fact that the National Football League is designed, via salary caps and rookie draft orders, to promote competition in the league.

How do they do it, then? One explanation is that the Patriots organization has some structural advantages that help them to win year after year. Having Tom Brady at quarterback and Bill Belichick as the coach – two of the all-time legends – doesn’t hurt. But the front office’s skill at identifying talent and the team’s winning culture also matter a great deal. Even with similar pots of money, other teams in the league have not been able to replicate the Patriots’ success.

What is a moat

Like the NFL’s league structure, capitalism should foster intense competition. If a company launches a successful product and generates high-profit margins, for example, competition should enter and whittle away the advantage.

Though these forces are still at work, some companies find a way to win year after year.

The likely explanation is that some companies have an “economic moat” – i.e. a durable competitive advantage – that keeps competitors at bay. 

There are four broad moat sources:

  • Intangible assets: These can be brands, patents, or regulatory licenses that make it difficult for upstart competitors to enter the company’s market.
  • Network effects: As new users join the company’s product platform, the platform becomes more valuable to all users.
  • Low-cost production: The company produces similar goods as its competitors, but does it at a much lower price per unit.
  • Switching costs: If it’s costly – either in time or money – for a customer to stop using a company’s product or if the product is a “mission-critical” component, the company benefits from a switching cost advantage.

When evaluating moats, a key question to ask yourself is, “Money aside, what would stop me from competing and winning against this company?”

It is not easy for a company to obtain one of the above moat sources. Smart, well-financed, and driven competitors are always trying to catch up. And eventually, they will. It’s just a question of how long it will take.

A true moat should enable the company to generate returns on invested capital above its cost of capital for at least ten years.

What’s not a moat

Too often, the phrase “economic moat” gets thrown around as a buzzword in investor and analyst circles.

Why might this be? We’re currently in a healthy market and economy and mediocre companies look better with favorable winds at their back. It’s easy to explain recent successes as being due to an economic moat, even if one does not exist.

If you’re looking at stocks yourself or with a financial advisor, I would be skeptical of any competitive advantage arguments that are based on the following.

  • Brand recognition: A brand becomes a moat source only if it allows the company to charge a higher price for the product. (Importantly, higher costs alone cannot explain the higher price.) Though you’ve heard of Delta and United Airlines, for example, would you pay 25% more to fly one of them versus another airline on the same route? Probably not.  
  • Market share: A significant market share could be indicative of a moat, but in itself, it is not a moat. For example, according to Statista, Nokia had a 50% share of the global smartphone market in 2007. By 2013, however, Nokia’s share fell as low as 3% following intense competitive pressures from Apple and other smartphone manufacturers.
  • Recent performance: One of the biggest mistakes an investor can make is misinterpreting a positive cyclical trend with a secular trend. Commodity producers often exhibit impressive returns on invested capital when their chosen commodity is rallying. Mistaking these cyclical boom times for a sustainable environment is a recipe for losses.
  • Management: While a great CEO and CFO team can build (or destroy) a moat, they are not a moat themselves. After all, they can decide to leave the company at any time.
  • History: A track record of impressive profitability or returns on invested capital might suggest a moat was once in place. The investor’s job, however, is to look forward. If previous advantages are no longer present, the company does not have an economic moat.

To be sure, concluding that a company has an economic moat today is not enough. Moat analysis is a fluid exercise because an industry’s competitive dynamics are never static. Moats can become wider or narrower with time.

Still, knowing what to look for in an economic moat can be a valuable exercise. If you invest in a company that consistently generates returns above the market’s expectations, you have a good chance at making money on the investment.

Bottom line

At Johnson, we aim to own quality businesses, whether they are large, small, domestic or international. Economic moat analysis is one step in my process for reviewing a company’s overall quality, which also includes an evaluation of management skill and integrity, earnings quality, and balance sheet strength. 

Stay patient, stay focused.

Best,

Todd

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(Cover photo: Old Wardour Castle)

Disclaimer

Todd Wenning is a Research Analyst with Johnson Investment Counsel (“Johnson”). Some Johnson clients own shares of Apple.

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