Intro
Not too long ago, lords and ladies used to build castles and dig deep moats around them to protect their wealth and well-being from intruders. Today, luckily, people do not have to fear for their lives like in the old days, but businesses still do.
Companies in a capitalistic society live in a cut-throat environment, where, if you happen to find a business niche that is exceptionally profitable, competition will come for you.
Our guy Warren Buffett loves exceptionally profitable businesses, but he also hates having these profits being taken away by competition. Therefore, Buffett insists that having a moat around the business castle is perhaps the most important criterion of all when investing in stock market companies.
And he is not looking for small ponds either, these moats should be as wide as possible.
“We think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And to our managers, we say that we want the moat widened every year.”
In this video, you’ll learn how to identify companies that can remain profitable in the long run, perhaps one of the most important skills that a value investor can possess.
This is the Swedish Investor, bringing you the best tips and tools for reaching financial freedom, through stock market investing.
What is a Moat?
Just in case you haven’t had enough of the metaphors yet, here’s a final one. Having an exceptionally profitable business is a little like having an exceptionally attractive partner. You know, there will be competition for such things.
In both cases, if you want to remain in your unusually favourable position, you’ll need a sustainable competitive advantage. That’s a mouthful, but this is exactly what Warren Buffett means with a moat, so let’s break it down.
“In business, a competitive advantage is the attribute that allows an organization to outperform its competitors” (Wikipedia).
Overperformance should be measured against competitors in the same industry, and against businesses in general, and usually means:
- Higher profitability
- Higher return on capital
- Large market share
To identify a competitive advantage, you can use a financial data provider such as TIKR and look at the historical numbers. I’ll show you how to do this quickly and for free by the end of this video.
Then we have sustainable. This is the dark art of investing, the sort of thing that makes it so that it is not necessarily academics with great mathematical skills that become the best investors.
Because the durability of a moat is very difficult to measure in numbers. There’s no formula that gives you that precisely, you know, that says that the moat is 28 feet wide and 16 feet deep, you know, or anything of the sort.
You have to understand the businesses.
Because a moat isn’t measurable so easily, people aren’t that great at identifying them. And in investing, when the herd is having trouble with something …
Do you smell that? What’s that smell? Opportunity.
The Key Question to Identify Moats
You know, every time I look at a business — when we bought See’s Candy in 1972, I said to myself, if I had a hundred million dollars and I wanted to go in and take on See’s Candy, could I do it?
And I came to the conclusion, no, so we bought See’s Candy.
Buffett has a similar quote about taking over Coca-Cola’s position as the leading soft drink company but this time with $100 billion.
His conclusion is the same: it can’t be done.
Whenever it is impossible to dethrone a business earning $7-10 billion per year even with $100 billion, you know that the said business possesses a very wide moat.
Entrepreneurs with a knack for expected value won’t even bother competing in these types of scenarios, and those who stubbornly try nonetheless will bleed.
However, remember that answering this question is an art, not a science. The quickest way to understanding the art is probably to observe a few of Warren Buffett’s most important investments.
The Business Moats of Berkshire Hathaway
If you can place yourself in the shoes of a customer of a company, chances are that you’ll understand if that business has a moat or not. Let me give you a few examples.
Coca-Cola
Coca-Cola has been the leading soft drink in the world for a very long period of time. Almost 2 billion servings of Coca-Cola company drinks are consumed each day. And it hasn’t achieved this market penetration at the expense of profitability either.
What is it that makes Coke so special? Collectively, Warren Buffett refers to Coke’s moat as “share of mind”. What he means by this is that in billions of peoples’ minds, all over the world, there’s something favourable associated with the brand name Coca-Cola.
It means something to them, probably “refreshment” or “happiness” or something along those lines. And any time a customer would like to feel refreshed, there’s a Coke within an arm’s length, thanks to the company’s incredible distribution system, which is a moat, too.
The company wants its customers to continue their habit of drinking Coke, and they should never be forced to choose, say, the Swedish Cuba Cola instead, because there wasn’t a Coke nearby.
These are the things that make Coke’s competitive advantage sustainable, and it will most likely be around in 20 or 30 years too.
Apple
Another company with a huge moat is Apple, which currently is Buffett’s largest public investment by a landslide. Its competitive advantage is like Coke in that it has a strong brand name and a positive “share of mind,” but there are two other things that I’d like to point out too.
- Network effects: The more people that join the Apple community, the more valuable it becomes.
- Technical lock-in effects: Many Apple users hesitate to switch systems because of the inconvenience and potential data transfer issues.
BNSF
BNSF is one of two really large railway companies in North America. Its moat lies in the enormous capital and time required to replicate its railway network.
See’s Candy
See’s Candy benefits from share of mind locally in California. Its premium chocolate is often purchased for special occasions, making it hard for customers to switch to cheaper alternatives.
GEICO
GEICO stands out as a low-cost producer in a price-sensitive auto insurance market, reinforcing its sustainable moat.
All Moats Are Not Created Equal
Not all moats last forever. Industries in flux, like social media, demonstrate how competitive positions can quickly change. Coca-Cola, however, has remained dominant for over 100 years, highlighting the strength of its moat.
Finding Businesses with Moats Quickly
A great starting point for finding businesses with moats is their past performance. Tools like TIKR simplify the process by screening companies with competitive advantages, saving investors valuable time.
Conclusion
To build a portfolio of impregnable castles, start by identifying companies with durable moats. For more insights, check out Warren Buffett’s 25 most important investments. Cheers!
