This post aims to examine the “moat” as an investing thesis, exploring its strengths, limitations, and the potential biases it can introduce. We will delve into the challenges of evaluating moats, and the limitations of moat-based investing and propose a more holistic approach to investment analysis beyond this popular concept.
Warren Buffett, one of the most successful investors of our time, famously said:
“In business, I look for economic castles protected by unbreachable moats.”
“A good business is like a strong castle with a deep moat around it. I want sharks in the moat. I want it untouchable.”
These metaphors have captivated investors for decades, leading many to believe that identifying and investing in companies with strong “moats” is the key to successful investing. But is investing all about the moats?
In investing, a moat is a metaphor for a company’s ability to maintain a competitive advantage over its rivals. Just as a castle moat protects against invaders, a company’s moat is thought to safeguard its market share and profits from competitors. This concept has become so ingrained in investment philosophy that moat analysis is often considered a must-have skill for investors.
Companies can build moats through various means:
- Strong brands (e.g., Coca-Cola, McDonald’s, Apple, Nike)
- Innovation and intellectual property (e.g., Eli Lilly, ASML Holding, Nvidia)
- Cost advantages (e.g., Amazon, Costco)
- High switching costs (e.g., Microsoft, Oracle, Salesforce)
- Network effects (e.g., Airbnb, YouTube, Netflix, Facebook, Visa)
Many companies have a combination of different moats that make them more unbreachable. For example: Microsoft has a strong brand, network effects and high switching costs with its products and services. The same applies to many well-established large companies.
Conventional wisdom suggests that companies with strong moats are more likely to:
- Maintain high profitability
- Generate consistent cash flow
- Withstand economic downturns
The Case for Moats
Many successful investors and analysts have emphasised the importance of economic moats in their investment strategies. Here are some key arguments:
- Historical success: Proponents argue that the long-term success of investors like Warren Buffett demonstrates the enduring value of moat-based investing. Companies like Coca-Cola and American Express have maintained strong competitive positions for decades, rewarding patient investors.
- Quality filter: Focusing on moats helps filter out lower-quality businesses, potentially reducing portfolio risk. This approach encourages investors to seek companies with sustainable competitive advantages.
- Adaptable moats: While moats can erode, strong companies continually adapt and reinforce their competitive advantages. For example, Microsoft’s shift to cloud computing has strengthened its market position in the digital age.
- Digital economy moats: In the digital era, network effects and data advantages can create even stronger moats than in traditional industries. Companies like Google or Facebook are often cited as examples of nearly unassailable market positions.
- Long-term thinking: Moat-based investing encourages a long-term perspective. It can lead to better returns compared to short-term trading strategies. This aligns with the principle of investing in businesses for the long term rather than merely trading stocks.
- Quantifiable aspects: While moats have qualitative elements, some investors have developed quantitative metrics to assess moat strength, such as consistent revenue, profit and cash flow growth and consistently high returns on invested capital (ROIC) over time.
- Competitive dynamics: Understanding moats is crucial for assessing industry dynamics and competitive positioning, even if it’s not the only factor in investment decisions.
Moat-based analysis remains a valuable tool as part of due diligence.
Challenges in Evaluating Moats
While valuable, moat may oversimplify the complex realities of business. Our understanding of moats can be biased and potentially misleading in our investment decisions. As markets evolve rapidly and disruption becomes the norm, the belief that “moat is unbreachable” becomes less relevant. Moat has become less durable.
Qualitative nature of moats: How to value moats?
Subjectivity: Moats often involve intangible assets like brand reputation, customer loyalty, or technological prowess, which are difficult to quantify.
Dynamic nature: Moats can erode over time due to changing market conditions, technological advancements, or shifts in consumer preferences.
In 2007, Nokia held a 50% market share in mobile phones, with a seemingly unassailable moat. By 2013, its market share had plummeted to 3% as smartphones took over. This stark reversal serves as a potent reminder that even the strongest moats can be breached by disruptive innovation.
Moat is not static. Hence, we cannot buy and forget with our investments. We have to keep validating the strength of their moats.
It is not about the companies having a strong moat; it is about others creating something cheaper, better and faster that will undermine the company. Strong brands and customer loyalty do not mean customers will always buy from Apple, Nike and McDonald’s. Customers may slowly be buying others (such as On Shoes, Lululemon and Chipotle). While strong brands are a moat, many other things matter too to ensure the moat remains strong. Companies cannot rest on their laurels; they must stay competitive and relevant.
Extending from the moat metaphor, it is not just about having a deep and wide trench. With technology, invaders are not coming from the land; the castle can be attacked from the air with missiles, fighter jets or drones.
Lack of industry knowledge: Can we understand the moat?
Complexity: Understanding the nuances of a specific industry requires extensive research and expertise.
Rapid change: Startups and companies are innovating to make products and services cheaper, better and faster. Existing companies have to evolve to stay up-to-date.
It can be difficult for retail investors to understand companies’ moats well if they are unfamiliar with the sector. It is not easy to understand Nvidia’s chip superiority for AI, differentiate the service offerings of various cybersecurity companies, and understand the moats of banks, manufacturers or component suppliers in the value chain.
Bias and narratives: The moat versus the story
Investor psychology: Emotional factors like fear, greed, and herd mentality can influence perceptions of a company’s moat.
Influence: We can be easily influenced by media, analysts, competitors and companies themselves on our understanding of the competitive advantages of the companies. Our understanding of the moat of the companies may not be objective and independent.
Limitations of Moat-Based Investing
Moat investing = Successful companies with strong market positions
Moat-based investing assumes the company has strong and durable competitive advantages in more stable sectors. These companies are already doing well, and successful with leading market leadership positions. These can also be established small and medium-sized companies in a niche and specialised or localised sector (Xpel – a leading provider of protective films and coatings). The concept of the moat is more applicable to a certain profile of companies.
Moat builders/challengers
On the other hand, we have young growth and disruptive companies building moat and challenging the status quo (examples: Uber, Airbnb, OpenAI/ChatGPT). We invest in these companies believing they are on the path to creating strong high-valuable moats. Here, we are investing in their vision, leadership, resilience and adaptability to develop their moats.
Investing > Moat
Investing is more than moat. There are different types of investing such as value investing, growth investing and dividend investing and the role of moat in investing differs.
- Investors are looking for mispriced and cheap stocks to invest in. These can be hidden gems and turnarounds.
- Investors into young growth and disruptive companies are looking at companies that are still building their moats or challenging the status quo (as discussed earlier).
- Dividend investors are more concerned about the strength of the moats to have a stable stream of dividends.
While moats mean competitive advantages for their products and services, demand and growth are also influenced by changing economic situations, changing consumer preferences, and the availability of cheaper better alternatives.
A company is what its leaders and people are. It is important to remember that a company’s moat is never set in stone. It is constantly being shaped and influenced by a range of factors, including the people at the helm of the organization. A strong leadership team can make strategic decisions that reinforce and expand the company’s competitive advantages, or they can make missteps that erode the moat. Take Amazon and Tesla for example. Both companies have built incredibly strong moats over the years, but those moats are only as strong as the leaders who guide them. Poor strategic decisions and operational, financial and risk management can weaken the company, even the companies enjoy strong moats (Disney). Hence, a strong moat does not guarantee the company will continue to do well in the future. Many moving parts make our investments great.
Beyond Moats: A Holistic Approach to Investing
Validate and quantify the moat
Aswath Damodaran of NYU explained that all qualitative factors (strengthening moat, improving fundamentals, improving macros, insiders buying) will show up in financial performance over time. The ability to grow its revenue, and maintain or increase its margins and free cash flow over time is the ultimate validation of the quality and demand of the products, leadership, durability and sustainability of its moat and the size of the total addressable market. Metrics such as return on invested capital (ROIC), free cash flow margin, and free cash flow yield are useful metrics for ascertaining the quality of companies. Ultimately, what is the expectation? Is the valuation justified?
While the concept of economic moats remains a valuable tool in an investor’s arsenal, it should not be the sole or even primary basis for investment decisions. The limitations of moat-based investing – including the qualitative nature of moats, the challenge of accurate evaluation, and the dynamic nature of markets – underscore the need for a more comprehensive approach.
Key takeaways for investors:
- Recognize the value of moats, but don’t overemphasize them: While strong moats can indicate competitive advantage, they do not guarantee future success.
- Adopt a holistic view: Consider moats as part of a broader analysis that includes financial performance, market trends, management quality, and macroeconomic factors.
- Quantify where possible: Use financial metrics like gross and net margins, free cash flow margin, order book/order wins and ROIC/ROE to validate and measure the strength of a company’s competitive position.
- Always validate: Remember that moats can erode over time. Regularly reassess the competitive landscape and a company’s ability to adapt to changing conditions. Do not invest and forget.
- Look beyond established players: Don’t overlook smaller companies or those in niche markets that may be building formidable moats.
- Balance qualitative and quantitative analysis: Combine the narrative of a company’s competitive advantages with hard financial data for a more robust investment thesis.
- Diversify your approach: Different investment strategies (value, growth, dividend) may require different considerations of moats and other factors.
By adopting a more balanced and holistic approach, investors can make more informed, more objective and less biased decisions and potentially achieve better long-term results.
In the ever-evolving world of investing, the myth of the unbreachable moat gives way to a new reality: success belongs not to those behind the highest walls but to those most adept at navigating the changing tides of business and technology. The modern investor must look beyond the moat to see the full landscape of opportunity and risk.
It is not the strongest nor the most intelligent of species that survives, but the one that is most adaptable to change.
Charles Darwin.
