I have broken moats and structural advantages into three levels:
- Competitive Fortresses. This is the highest level and quite rare. The symbol I use is a castle on top of a mountain.
- Competitive Advantages. These are advantages versus current rivals, both large and small. I have placed competitive advantages higher up as they are usually stronger and more durable. They are also more rare. My symbol for this is a sword and a shield. Competitive advantages can usually be used for both offense and defense.
- Barriers to Entry and Soft Advantages. These create competitive defensibility against new entrants. They are mostly about barriers to entry. But there are also some interesting soft advantages in this category that can be effective against rivals as well. Digital platforms, in particular, are creating lots of new soft advantages and entry barriers. The symbol here is a spiked wall.
That is my framework, which is pretty detailed. Each of those levels has lots of components. But I find it useful for doing a qualitative assessment of a company’s moat. This is 50% of how I measure moats.
There are other qualitative assessments. Hamilton Helmer uses is list of 7 Powers. Morningstar has an economic moat rating for its companies. I don’t find those detailed enough.
When I was in business school, I was taught about competitive strength with an analogy to snowballs and treadmills. This is more of a high-level, instead of a component-level, description. The argument goes:
Most companies are running on treadmills.
- They have no real structural advantages. So competition is all about operations and execution of the same activities others are doing.
- They are continually running against their competitors, including large rivals, small rivals and new entrants.
- This usually means little operating cash produced for owners as the company is constantly spending money to upgrade facilities, increase scale and so on. You are on a treadmill without making much financial progress. And with no finish line.
- The ROIC eventually becomes close to WACC. Earnings Power Value is usually equal or less than Asset Value.
- And this running on a treadmill activity never stops. You have to do it forever to stay in business. And you never really get anywhere in terms of returns or building advantages.
- Running a marathon, however, is different than running on a treadmill.
“There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, “There’s all of my profit.” We hate that kind of business.” – Charlie Munger
A small number of companies are snowballs rolling down a hill.
- These businesses have moats and structural advantages that protect them from most competition, especially smaller rivals and new entrants.
- Competition is usually much less intense operationally. Mars chocolate and Facebook are not competing nearly as ferociously as the typical restaurant.
- These companies are often cash producers, benefiting owners and management. Although this depends on how capital intensive the company is and the general profitability of the industry (i.e., base rates).
- ROIC tends to be significantly higher than WACC.
- The mental image is a snowball rolling down a hill, growing in size without much effort.
- Note: The biography of Warren Buffett by Alice Schroeder is titled The Snowball.
“Life is like a snowball. The important thing is finding wet snow and a really long hill” – Warren Buffett
Treadmills vs. snowballs is a helpful high-level analogy. But it doesn’t get you very far in digital businesses. You need to look much more at the components of the structural advantage. To see which ones are changing and not.
The snowball analogy also mixes together three different ideas. Companies are usually on three big factors:
- Market size and growth
- Competitive strength and defensibility
- Unit economics
There are lots of other factors, of course. But those are the three that get you an estimate of economic profits created. And you can see that implied in the snowball analogy. It gets bigger as it goes down the hill. I agree that you definitely want to avoid treadmills. But there are also lots of well-defended companies that are not snowballs.
I’m looking only at the second factor, competitive strength and defensibility. A company with good competitive strength does not necessarily have attractive unit economics. And it may not have the opportunity or economics for rapid growth. There is no reason a particularly well defended business has to be in a very big market either. In fact, the vast majority of them aren’t.
A Moat Shows Up in Market Share Stability and/or ROIC Relative to Competitors. Or It Doesn’t Exist.
So that’s a qualitative assessment of a moat. But what about quantitative?
These you can break into specific measures for each structural component – and this varies by industry and component. But you can also look for two main outcome metrics.
- A (ROIC – WACC) that is higher than competitors when averaged over time.
- Market share entry and share stability, by revenue and/or volume, relative to competitors over time.
More on these in a moment.
Keep in mind, lots of things can impact the trajectory of a business going-forward. Technology changes. Regulatory changes. Changes in consumer behavior. And of course, digital change.
But competitor actions usually have the most immediate impact. If the competing chicken restaurant across the street drops the price of a 3-piece dinner by 20%, you probably have to respond or your sales will decrease. If they increase their marketing spend by 20%, you probably have to respond. If they spend some capex and build a children’s play center, you probably have to spend too. Competitor moves can impact virtually every line of the income statement in almost real time. This is what makes undefended companies so hard to project (and value) into the future. The operating earnings are too unpredictable. Which directly drives valuation.
Unless you have a moat. An example:
- Most of the coffee places in a typical neighborhood make an operating profit and have a positive return on invested capital (ROIC). But the Starbucks on the street seems to be a bit higher on both operating profit and ROIC.
- When the coffee place across the street drops its prices by 20%, all the other coffee outlets have to decide whether to match it. Most do. But not Starbucks. It does nothing in response.
- Over time, we can see market share shift back and forth between the coffee outlets on the street. But Starbucks seems to keep the same traffic year after year. And it is trending upwards.
- When a new metro station is opened nearby, everyone does more business. But Starbucks increases more than the others.
- When the local retail coffee market suddenly drops by 30% because of decreased tourism, everyone gets hit. But Starbucks gets hit less.
- Regardless of what the competitors do, Starbucks just keeps doing the same thing. And over time, it keeps increasing its marketing spend and offering more loyalty programs. And it frequently moves to a larger location with more visibility and traffic.
Compare the Starbucks to the restaurant analogy. That’s a company with a moat. It is just significantly less impacted by competitor moves and by adverse events in the market. It also benefits more from improvements in the market. And it just keeps running its own playbook, which is about growing its moats.
And when we look at the outcome measure for this type of protected company, we are going to see it in one or both of two metrics.
- A (ROIC – WACC) that is higher than its competitors when averaged over time. Return on invested capital (ROIC) minus the weighted average cost of capital (WACC) is the economic profitability of the comapny (after cost of capital). That’s not the same as the operating profit. It’s about economic profit. A company with a moat will often (but not always) show up in significant and sustained increases in its economic profitability (ROIC) versus some market participants. That doesn’t mean it is exceptionally profitable. You can be in a low profit or negative profit industry and have a moat advantage. It just means it is higher than others.
- Market share entry and share stability, by revenue and/or volume, relative to competitors over time. We are looking for greater market share stability over time. Market share should not shift significantly for this company. And if it does, it is small and significantly lower than most competitors. There should also be few new entrants and/or lots of failed entry attempts. That is almost the definition of a moat. Nobody can take your customers, even thoughts lots have tried.
The ROIC-WACC metric is important – but people often start by looking for +10-15% ROIC in absolute terms. Because they are thinking about a snowball. But this is a relative metric. Having a moat doesn’t mean a company has a high ROIC. It may not be in a high ROIC business. It just has a higher ROIC than competitors. Don’t underestimate the value of a nice local supermarket predictably making 8% ROIC while everyone else is making 4%. It isn’t a cash machine. It’s not a big wealth generator. But it can be very predictable. Management can protect their business and careers. And for investors, it can be a great place to preserve wealth. Or to make a nice return if it happens to be on sale one day.
I usually look at the market share entry and share stability metric much more. This can be measured by revenue or by a key operating activity. That distinction is important in many digital businesses where you can separate engagement from monetization. If nobody can take a significant part of a business, then, by definition, it has a moat that protects it.
However, absolute market share stability is rare. Again, this is usually relative to other competitors. In most businesses, a certain market percentage changes hands every year. This can be between a small number of dominant players, like Coke and Pepsi. And it can be between the dominant players (Coke + Pepsi) and all the smaller players and new entrants. Coke and Pepsi may trade 3-5% market share yearly in certain markets. But Coke and Pepsi together lose virtually no combined market share to new entrants and smaller players yearly. At least, not to direct cola competitors. Substitutes is another subject.
The key word here for both of these metrics is “relative”. What is the ROIC and market share stability relative to large rivals. Relative to smaller rivals. Relative to new entrants. Relative to substitutes.
The other key phrase is “over time”. Ideally, you want to look at a rolling average over 1-2 business cycles. Lots of things can happen in the short-term, especially when the market is growing rapidly. Or when a new business model or product / service is emerging. And especially when companies decide to forgo profits (and ROIC) and go for growth and/or market share.
For tech companies and for companies with significant digital change, we rarely get to see a 1-2 business cycle average picture. More likely what we see is a strengthening or declining situation where we can’t get a rolling average. But we can get a strong directional indicator.
And, finally, you need to think about “sustainability”. Are these metrics stable, increasing or decreasing? How long will they last? 8 years is routinely cited as the average life span of a moat. But I don’t buy that at all in digital. You want to assess it at the component level and usually ignore such averages.
Ultimately, measuring a moat is a judgement call based on qualitative and quantitative factors.
At a minimum, moats will get a company an increased degree of defensibility against current and potential competitors. At the maximum, moats get a company the competitive strength to take down competitors. And to scare off new entrants. That’s why I keep using the phrase competitive strength and defensibility. Moats can be both offense and defense.
Finally, the bonus gift of moats is they give you far greater predictability as an analyst, manager, financier or investor. It’s why it’s such a good dimension for projecting 3-5 years into the future (which is usually what I am thinking about). You really can predict a range for Starbucks’ operating performance 3-5 years into the future (note: make sure you capitalize the leases). And I think it is the only good approach for predicting companies under digital change.
That’s it for today. Cheers, jeff
- Lessons from Warren Buffett on Compounding and Competitive Advantage (Asia Tech Strategy – Podcast 91)
From the Concept Library, concepts for this article are:
- Competitive Advantage
- Barriers to Entry and Soft Advantages
From the Company Library, companies for this article are:
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