The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors. –Warren Buffett (1999)

The most important thing to me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.” Warren E. Buffett (1994)

value creation

Measuring the Moat

Warren Buffett wants to buy businesses with prospects for sustainable value creation

Warren Buffett consistently emphasizes that he wants to buy businesses with prospects for sustainable value creation. He suggests that buying a business is like buying a castle surrounded by a moat and that he wants the moat to be deep and wide to fend off all competition. Economic moats are almost never stable. Because of competition, they are getting a little bit wider or narrower every day. This report develops a systematic framework to determine the size of a company’s moat.

Companies and investors use competitive strategy analysis for two very different purposes. Companies try to generate returns above the cost of capital, while investors try to anticipate revisions in expectations for financial performance. If a company’s share price already captures its prospects for sustainable value creation, investors should expect to earn a risk-adjusted market return.

Industry effects are the most important in the sustainability of high performance and a close second in the emergence of high performance. However, industry effects are much smaller than firm-specific factors for low performers. For companies that are below average, strategies and resources explain 90 percent or more of their returns.

Industry is the correct place to start an analysis of sustainable value creation

The industry is the correct place to start an analysis of sustainable value creation. We recommend getting a lay of the land, which includes a grasp of the participants and how they interact, an analysis of profit pools, and an assessment of industry stability. We follow this with an analysis of the five forces and a discussion of the disruptive innovation framework.

A clear understanding of how a company creates shareholder value is core to understanding sustainable value creation. We define three broad sources of added value: production advantages, consumer advantages, and external advantages.

How firms interact plays an important role in shaping sustainable value creation. We consider interaction through game theory as well as co-evolution.

Brands do not confer competitive advantage in and of themselves. Customers hire them to do a specific job. Brands that do those jobs reliably and cost effectively thrive. Brands only add value if they increase customer willingness to pay or if they reduce the cost to provide the good or service.

Note on page 12 the industry map. Full PDF here:

Measuring_the_Moat_July2013

Via csinvesting.org