Moats Checklist— April 14, 2013
Moat is a term introduced by Warren Buffet through his letters to the shareholders of Berkshire Hathaway. According to Buffet to be a successful investor one should seek “economic castles protected by unbreachable ‘moats.’ ”
What is Moat ?
In medieval times, castle architects incorporated a variety of defenses and traps intended to slow, injure or kill attackers in order to hold the castle as long as possible, against even the largest attacking armies.
source National Geographic
Buffet used the term Moat to describe the durable competitive advantage of a business. He compared it to the Moat that protects a castle. According to Buffet Assessing the Moat of a business involves understanding what kind of defense, or competitive barrier, the company has been able to build for itself in its industry.
According to Morningstar
An economic moat is a long-term competitive advantage that allows a company to earn oversized profits over time. Quite simply, companies with a wide moat will create value for themselves and their shareholders over the long haul, and these are the companies you should focus your attention on.
Why are Moats important ?
Moats are important for investors because any time a company develops a profitable business model by developing new product or service, other companies or competitors try to capitalize on that opportunity by producing a similar if not better product.
Existence of strong competitive advantage (a.k.a Moat ) makes it difficult if not impossible for competitors to enter the market and erode the profits.
How do you identify a company with a strong Moat ?
A Business has Moat if one or more of the following are true
Economy of Scale or low cost producer in its area
- Retailers or Manufacturers with high fixed costs or distribution network will have cost advantage over smaller players in the industry.
- Large companies with range of operations can use scale to provide a range of services to its customers that its competitors can’t
Wal-Mart is perhaps the most salient example of a company benefiting from economies of scale, and for good reason. As a dominant player in retailing, the company’s size provides it with enormous efficiencies that it uses to keep costs low.
Exclusive Access / Rights
- Access or rights to resources which are hard to acquire ( land, mine, etc )
- Access to patents or copyrights that patents competition for certain period
Waste Management companies or Railways have exclusive access/rights to lands which provides them with a strong competitive advantage against other companies.
Pharmaceutical companies and tech companies benefit due to patent protected technology or drugs that prevents competitors from entering the market segment.
- Strong brand loyalty due to superior products, user experience or customer focus [ think Amazon, Google, Apple etc ]
- Has the mind share of the society
- perpetual availability of its product (think coco-cola , you can’t find a place in U.S where its hard to find a coke )
Google is synonymous with search and it has captured the mindshare of the society. It’s hard for other players to grab search market share from Google
- The viability of the product is strong as more people use it ( ex : Credit cards, Social Networks )
- Its hard to imitate when you need to develop the network from scratch.
Linkedin and Facebook dominate their respective market segment as more people use the product, they become more valuable to the users. If all my friends are in Facebook why would I use any other social network.
High Switching Costs
- Products that are so deeply entrenched in your business that its economical to live with frequent raises in service cost than switching to a new product
As a software engineer I have worked on projects to replace or upgrade legacy ERP systems. I have noticed that most of the systems are easily replaceable except database (think Oracle) and SOR systems or Mainframes (think IBM) thats a huge advantage for these companies as the switching costs are too high for the customers.
Signs of Moat in a Business
- Large -ve working capital, absence of debt , a liquid balance sheet and high ROEC
- Large and slow moving Floats ( Go where float is going to be not where it is )
- Stable or increasing Size of float relative to assets,debt and revenue over time.
- Presence of float makes debt unnecessary
- Focus on Enterprise Value not Market Cap when you look for a business with Moat, Lesser the EV better the Moat
Beware of Moat traps
- Business with mediocre ROA but high ROEC because they have large trade credit ( problem : it can go away for any reason )
- Cyclical floats : Floats that are not similar to revolving funds – think of iron ore suppliers who can command high prices when there are shortages or demand surge but thats not permanent.
- Financial shenanigans : large trade credits with implicit cost to understate reported debt
- Surplus cash due to float ( free float is the best form of leverage )
It seems like Buffet is also focused on finndig businesses that are operating efficiently and effectively (per his criteria in the shareholder letters) and that have great managers. Unfortunately, assessing management’s ability is one of the harder jobs (in my opinion). Especially as a retail investor, as it is hard enough to get responses from most company’s investor relationships, much less actually talking with senior management.It also seems that as Berkshire Hathaway has grown, that he is focusing more on capital intensive businesses (other than the insurance section of the company), such as the railroad and Mid American, as they are about the only things that can really even attempt to move overall earnings at this point.