Friday, 16th October 2015

Business Moats

Written by George Traganidas Topics: Stock Investing, Wealth Building

Moat

One of the tasks of an analyst who is evaluating a business is to think about the moat of the business. But what is a moat? A simple way to think about moats is to imagine that the business is a castle and the moat it what surrounds the business and keeps other businesses at bay. Every business has a moat, but the difference is the size and the durability. Some businesses have narrow moats and other have wide ones. Some business moats are shrinking as time goes by, whereas others are widening. Ideally an analyst wants to find a business with a wide moat that keeps widening. One of the characteristics of the capitalist system is that a profitable business will attract more and more competitors and these competitors will test your moat repeatedly. Thus, the more successful a business is the harder it is to keep being successful and widen its moat.

There are different ways that a company can build a wide moat. A really successful business combines a few of these ways and creates a Lollapalooza effect. This is a term that Charlie Munger uses to describe when two or three or more forces are acting in the same direction and the combined effect is much greater than the sum of the parts.

This list contains some of the most important moats that a company can have:

  • Supply-side. A company can have many clients and thus sell a lot of merchandise to them. This gives the company purchasing power with its suppliers and it can obtain better terms than the average company. Example of companies that have this kind of moat is Wal-Mart and Costco.
  • Demand-side. A company can have many customers who use their services and the big number of the customers makes the service better and more valuable and this attracts even more customers. Example of companies that have this kind of moat is Ebay and Amazon.
  • Local economies of scale. A company that has high fixed costs operates in a ‘small’ market. A competitor would have to incur all these fixed costs, but the market is not big enough to provide positive returns to two companies. Example of a company that has this kind of moat is Nebraska Furniture Mart.
  • Brand. A company can have such a well-recognised brand that it can command a premium for its products and raise prices without losing customers. Example of companies that have this kind of moat is Coca Cola and Disney.
  • Regulation. A company can be protected by regulation that stops competitors from entering its industry. Example of companies that have this kind of moat is Moody’s and banks.
  • Patents and Intellectual property. A company can have many patents that protect its assets. Example of a company that has this kind of moat is Qualcomm.
  • Switching costs. A company can provide a service or a product to its clients and make them dependent on it more and more as time goes by. Switching away to a competitor becomes harder with time. Example of a company that has this kind of moat is IBM.
  • Unique resources. A company can have access to a resource that is unique or it is extremely hard to replicate. Example of companies that have this kind of moat is railroads.
  • Human capital. A company can have a CEO who is a fanatic. Example of companies that have this kind of moat was Apple under Steve Jobs and GE under Jack Welch.

After you have identified a business with a wide moat then you need to see if the moat is durable and if it will shrink or widen in the future. In order to answer this question you need to identify what causes this business to have a wide moat at present and then forecast what future events can cause this moat to become narrower.

One way to think about the durability of the moat is to perform the following thorough experiments. Let’s assume a company called ABC. If someone gave you $100bn could you build a business to compete with it? This should force you to think hard about what kind of moat ABC has and if it can be narrowed because someone with more money has started to compete with ABC.

Some people would argue that having a wide and durable moat is the most important thing when you are looking for a business to invest in the long term. If the moat is missing nothing else matters because the company will be crashed by the competition in a capitalist system. What is important to remember though is that even the strongest moats can become very weak with the passage of time and as new competitors come in with more innovative ideas. That is why the job of the business owner is to be always vigilant and look to widen its moat every year.

Follow the practical way,
George

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