What Makes a Moat “Defensible”?
Q: If a “moat” is a set of characteristics that help to protect a company against financial or commercial harm, how can you tell if their moat is durable, defensible, and growing?
As value investors, we are always on the lookout for companies that offer core value that will stand the test of time. Necessarily, their defense against devaluation or financial harm must be strong and enduring. That means we want companies that possess a set of characteristics that hardens a company against attack by competitors or being undermined by internal failures that could ultimately damage financial standing. I wrote last year about what characteristics make an effective moat, including high switching costs, economies of scale, high return on capital, etc.
But how can we tell if the characteristics that make them strong will last over the timespan we envision? Here, we’re asking about the quality of the moat.
Unfortunately, it’s not always easy answering this question. There are certainly industries that might give a superficial impression of having a moat but aren’t nearly as well-positioned as they seem.
Cable companies are a classic example. For years, they had monopolistic or duopolistic access to consumers. That exclusivity created a moat the seemed very durable for a long time, but there was weakness under the surface because their customers were often dissatisfied by poor service and exorbitant fees. They were just trapped by an absence of meaningful alternatives.
So, when those competitive lines began to get blurred or disrupted by the rise of streaming services, many people began cutting the cord and finding cheaper alternatives. If the cable companies had had more customer goodwill and loyalty when plausible alternatives started arising, they might have enjoyed a more durable moat. Instead, Netflix surpassed even the largest cable pay-TV providers in subscriber count way back in 2017. Cable and satellite companies lost 4.7 million customers just in 2021.
But what about the reverse situation? What if they’d had loyal customers but without the geographic lock on them? That alone may not have been enough either. Customer goodwill and loyalty are often central to a defensible moat, but they’re not sufficient by themselves.
Indeed, there’s no single characteristic or hard-and-fast rule about creating or maintaining a defensible moat over time. We have to look at the whole picture. Whenever we assess an industry or asset, we’re going to find a lot of embedded complexity and idiosyncratic factors. In other words, if you’ve seen one moat, you’ve only seen one moat.
That said, deteriorating moats will usually translate into eroding quantifiable metrics. If you see a company that looks profitable and might appear to have a valuable moat, but at the same time it has customers that aren't fans (as measurable by something like a very low Net Promoter Score or equivalent metric), then that's a red flag. Similarly, if revenues and margins are trending down, that’s another big red flag.
One key point, though, is that moats must be actively maintained.
A company like Amazon or Costco is always enhancing the value proposition, putting their profits back into the business in ways designed to improve customer experience. Amazon, for example, was not satisfied with just like three- or-four-day delivery and became much more aggressive about shorter delivery times, up to same-day. As part of that effort, they’ve pushed into the shipping and logistic market themselves (maybe weakening FedEx’s and UPS’s own moats in the process). Amazon also added more and more features into its Amazon Prime offering. Every step of the way, they’ve conscientiously and continuously strengthened their position.
Now Amazon is a dominant market power. Its willingness to constantly reinforce and build on its moat has increased its value proposition and competitive positioning, and that’s critical to finding moats that can stand the test of time.