- Glenn D. Surowiec
Q&A: What is a moat?
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You’ve brought up the concepts of “moats” and “margin of safety” in multiple Q&A answers. What do these ideas mean exactly? And if I’m looking for a “moat” or trying to verify that an investment has a good “margin of safety,” what should I be looking for exactly? What are some factors that might look like a moat, but aren’t one?
What is a moat?
Historically, a moat is a body of water that wraps around a castle or other structure and serves as a defense against attack. In investing, the term is obviously metaphorical, but it still works. It refers to any characteristic of a business or asset that insulates or defends it against competitors or other factors that could reduce value or harm financial standing.
Thus, a moat can help to create or increase the investor’s ‘margin of safety’ when making an investment. There are many kinds of moats, as I’ll detail next.
Economies of scale
Scale alone can be a moat. Think about Wal-Mart, Costco, and Amazon. These are organizations whose sheer scale and ability to create or leverage economies of scale can keep prices lower than everybody else.
That means they can absorb downturns better than others. This is particularly important for very price sensitive purchases, like commodity producers. A related concept is “network effect.” This is where the value derived from a product or service increases as more people use it (i.e., join the network).
Facebook is the perfect example here.
The network effect of Facebook is immense and drives a lot of its value. People join Facebook specifically because everyone they know is on it.
However, the benefit of economies of scale and network effects can be illusory. This gets back to factors that might look like a moat without being one.
Consider cable companies. These businesses have a lot of customers who pay them every month and are locked into contracts. Delinquencies are probably low. On paper, that looks like a great situation for producing value over time without much risk. But if you look deeper, you have a lot of customers that are unhappy and are increasingly “cutting the cable,” thanks to technologies like streaming that make access to content easier and less painful. Thus, they’re facing a lot more competition and pricing pressure than ever before, and their business model looks increasingly outdated. They have the economy of scale, but the underlying fundamentals around their business are highly questionable.
Sometimes the cost of switching to a competitor is just so high that people don’t want to deal with it. This decreases the risk of people leaving. That’s why some companies charge cancellation fees; if it’s free (easy) to cancel or go elsewhere, the customer is more likely to do it. If it’s costly in terms of money, time, and/or effort, they’re less likely to do it.
Sometimes you also get invested in a particular service such that moving to a competitor would mean starting over from scratch. Many software-as-a-service purchases are like this.
If you use Salesforce at your business, you don’t want to switch to another customer relationship manager because it might mean losing a lot of valuable data or having to do a lot of work to preserve that data.
Economies of scale and network effects also influence switching costs. For a company to really compete with Facebook, for example, think about how much money it would take to displace them. Given Facebook’s huge installed base that is attracted to Facebook because it already has a huge installed base, are people really going to just go elsewhere?
High return on capital
Having a lot of capital on hand is a huge moat. It means these companies have enough money to do almost anything they want:
Outspend competitors on advertising
Pour money into research and development to build a better product than competitors
Continue to pay their bills even in the face of an economic crisis
Acquire and absorb competitors before they become serious threats, and more
Companies like Alphabet (Google), Apple, and Microsoft are typically sitting on huge amounts of cash on hand – over $100 billion in some cases.
But this is another area that can look like a moat without actually being one. If you have a company that generates a lot of return on capital, people are going to want a piece of that, so they’ll throw a lot of capital at it. The question is, how much damage can they do? Not all businesses can withstand a flood of capital coming in. Some can; it wouldn’t displace them one bit. Others start making bad decisions and spending money just to spend money in ways that can turn self-destructive.
Patents and copyrights on intellectual property are a form of moat. Think about pharma companies that have exclusive rights to sell certain drugs. This allows them to monopolize a particular corner of the medical market without being a monopoly themselves. They’re totally insulated from competition for as long as they have that exclusive right, and if it’s a critical and popular medication, that exclusivity is a powerful moat.
Of course, another form of exclusivity is actual monopoly. If a company is the only one offering their product or service, then customers who want that product or service can’t go anywhere else.
Cable and internet companies might be example here too; 83.3 million Americans have only one option for Broadband Internet available to them. Whether this is a healthy situation is another question, but for as long as it lasts, it does create a moat around these companies.
A business simply being better at its service or product than its competitors is also a good moat.
Google is a great example here. Love them or hate them, Google has essentially created a searching platform that eclipses virtually all its competitors, even today. To the degree that Google is just better at what they do than others, they create a margin of safety around their offering that can increase value with less risk.
As I’ve already described, moats can be deceptive, and sometimes you think you’re looking at a moat, only to be wrong. Worse, businesses can sometimes erode or destroy their own moats through mismanagement or misfortune. So, when evaluating a potential investment’s moats, I’d advise keeping a few provisos in mind:
Working from old information: One of the biggest mistakes people make in looking for and evaluating moats is using information that’s no longer accurate. Back to cable companies: it’s easy to look at these businesses and think they still have the circumstances that are actually decades out of date.
No one lives forever: History is littered with companies that seemed untouchable but have since floundered or fallen. For a long time, Kodak seemed to have the ultimate moat, until technology caught up and passed them by. Gillette similarly had a fantastic business model for a long time, until the internet allowed other companies to come in and create a more efficient offering.
Too much of a good thing: Businesses will naturally take maximum advantage of any moat available to them. Gillette made great money by selling blades at huge margins, for example. But a fat margin built into products for no reason beyond “because we can” is vulnerable when the market changes enough that someone can produce similar quality at lower cost.
Poor management: There are a lot of moats that can be destroyed by lousy management. It's important to know who the stewards of the organization are – its executives and board members – and to make sure that they're operating with an appropriate level of discipline and critical thinking. When companies operate in uncompetitive environments for a long time, it’s almost like they forget how to think, so they don’t know what to do when a serious competitor suddenly arrives on their doorstep. Leaders need to always be thinking one step ahead of the markets – always. (And, for that matter, so do investors!)