Finding a company with a strong competitive advantage like an Apple (AAPL) is what every investor is looking for. It is not easy and there are not a lot of formulas that you can use to find them. We are all on the lookout for companies with wide investment moats. Especially value investors. We love these types of companies. Companies with wide investment moats are likely to be around for a long time, not that they are invincible. But they are great companies for growing wealth over time.
“But all the time, if you’ve got a wonderful castle, there are people out there who are going to try and attack it and take it away from you. And I want a castle that I can understand, but I want a castle with a moat around it.”
Warren Buffett from a talk he gave to MBA students at the University of Florida
What is the definition of an investment moat?
Charlie Munger and Warren Buffett are generally accepted as the originators of the term “moat”.
A moat refers to “business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.”
Competitive advantage is going to be any factor that allows a company to provide a good or service that is essentially the same as it’s competitors. But allowing them to beat their competitors in profits.
An example of this would be if you shop online for a product. Chances are you will see many different companies offering the same product but one stands out because they offer a lower price or perhaps free shipping.
This gives that company a competitive advantage over their competitors because of the free shipping, that the others may not be able or willing to offer.
The example of free shipping would be temporary, as the other companies would eventually start to offer that as well. But let’s say you’re company develops a way to deliver them quicker and more cheaply. The other companies can’t copy this method and that would lead to a bigger competitive advantage that would have some durability to it.
This is what we are looking for.
A company with the ability to create an advantage, other than price that others can’t replicate or copy for themselves to cross that moat.
Warren Buffett on Investment Moats
Another quote from his talk with the MBA students from Florida.
“I like businesses I can understand. We’ll start with that. That narrows it down about 90% [laughter]…There are all kinds of things I don’t understand, but fortunately, there’s enough I do understand. You got this big, wide world out there. Almost every company is publicly owned…You got all American business, practically, available to you. Now, to start with, it doesn’t make sense to go with things you think you can[‘t] understand. But you can understand some things. I can understand this [Picks up can of Coca Cola]. I mean you can understand this. Anybody can understand this. I mean this is a product that basically hasn’t been changed much…since 1886…and it’s a simple business. It’s not an easy business. I don’t want a business that’s easy for competitors. I want a business with a moat around it with a very valuable castle in the middle. And then I want…the Duke who’s in charge of that castle, to be honest, and hard-working and able. And then I want a big moat around the castle, and that moat can be various things.
The moat in a business like our auto insurance business at GEICO is low cost. I mean people have to buy auto insurance, so everybody’s going to have one auto insurance policy per car basically, or per driver. And…I can’t sell them twenty…but they have to buy one. What are they going to buy it on? They’re going to buy it based on service and cost. Most people will assume the service is fairly identical among companies, or close enough, so they’re going to do it on cost, so I gotta be the low-cost producer. That’s my moat. To the extent my costs get further lower than the other guy, I’ve thrown a couple of sharks into the moat.”
That pretty much sums up what Buffett thinks about moats and how he goes about looking for them.
His example of GEICO is one of the best examples out there. It is a product that everyone needs and is going to continue needing as long as they drive. And one of GEICO’s calling cards is their pricing. They are often the lowest and not many can compete with that price.
This gives them their moat. Because who wants to pay more for insurance. Nobody! I know I sure don’t. Most consider it a necessary evil.
Besides the pricing giving them an advantage over their competitors it also helps keep out other companies wishing to enter the market. GEICO can just lower the price to make it so unattractive to the other company that they won’t even compete. Again a moat is created with this barrier to entry.
Another concept that Buffett refers to is a promise or a share of mind. By this, he is referring to a given brand and the promise of quality a consumer can expect from that brand.
It’s all about trust and reputation. Think of Coke. When you open that bottle you know exactly what you are going to get every time. You trust the quality and taste. This gives the consumer confidence and reduces their risk of spending money for something they won’t like.
And for Coke, it gives them branding power, which can enable them to raise prices because people will often pay more for a brand they know and trust. As opposed to an unknown or unfamiliar brand that is cheaper.
This is also great for Coke because the branding helps with creating customers that will keep coming back for their product which helps create predictable and steady cash flows.
Charlie Munger on Investment Moats
“The difference between a good business and a bad business it is that good businesses throw up one easy decision after another. The bad businesses throw up painful decisions time after time.”
Munger feels so strongly about moats that he has included it as one of his famous “four essential filters” for locating great businesses to invest in.
Buffett and Munger have both said that they prefer to find great moats and buy them as opposed to trying to create them. They feel it is easier that way and they feel they are better at locating them, than creating them.
At the 2012 Berkshire meeting, Charlie said:
“We buy barriers. Building them is tough… Our great brands aren’t anything we’ve created. We’ve bought them. If you’re buying something at a huge discount to its replacement value and it is hard to replace, you have a big advantage. One competitor is enough to ruin a business running on small margins.”
For example, he believes that you don’t need to make hamburgers to see that McDonald’s has a moat. But don’t dream of building a burger joint to compete with them without someone like Ray Kroc running the show.
Munger believes that the creative genius and management of these