What Actually Makes a Business Impossible to Compete With

The Most Important Question in Business

In investing it has a memorable name: the economic moat the enduring advantage that protects a company's profits from competitors in the same way that a moat protects a castle. Warren Buffett built much of his fortune on a single idea: that the most important thing to understand about a company is the width and durability of its moat. A company without one sees the competition lose its high returns. A company with a deep portfolio can earn extraordinary profits for decades while its rivals beat themselves up against the competition.walls

Why Profits Are Supposed to Disappear

Basic economics says that high returns shouldn't last. When a company earns unusually high profits competitors are attracted and their competition drives prices and margins down toward the cost of capital until the excess returns disappear. So when a company manages to maintain high returns on invested capital year after year something must be blocking that natural process. That something is the moat. The whole job of competitive strategy analysis is to identify what the moat is and judge how long it can hold out

The Five Real Sources of a Moat

Lasting advantages almost always come from one of five sources. Network effects where each new user makes the product more valuable to everyone else as with payment networks and marketplaces. Switching costs when leaving is painful or costly as with enterprise software and banking relationships. Cost advantages where a company can simply produce cheaper due to scale location or process. Intangible assets i.e. trademarks patents and regulatory licenses that competitors cannotcopy.And efficient scale where a market is only large enough to support one or two players profitably. Wider moats typically combine several of them at once

A Worked Example: Why a Moat Makes Growth Worth 29 Times More

Moats are discussed qualitatively like a story about competitive position. There is a precise version and it explains something that trips up almost everyone who learns about valuation: growth is not automatically good

Let's take two companies with identical capital and identical growth plans. Both employ $10 billion of invested capital. Both face a cost of capital of 9 percent. Company A protected by a moat earns a 35 percent return on that capital. Company B in a competitive commodities business earns 10 percent

First of all the annual economic benefit. Economic profit is the differential between performance and the cost of capital multiplied by the capital employed

Company A: a spread of 26 points on 10 billion is equivalent to 2.6 billion dollars a year of true value creation. Company B: a spread of 1 point on the same 10 billion is 100 million. Same capital 26 times the value creation

Now the part that matters most which is what growth does. Suppose each company reinvests an additional billion dollars at its current performance

Company A earns 35 percent of that billion or $350 million a year in new after-tax profits. Capitalized at the 9 percent cost of capital that stream is worth 350 divided by 0.09 or about $3.9 billion. The company spent $1 billion to create $3.9 billion so it added about $2.9 billion in value

Company B earns 10 percent of its billion or 100 million a year which is 100 divided by 0.09 or about 1.1 billion. It spent 1 billion to create 1.1 billion adding about 100 million

The same billion dollars of growth is worth approximately 29 times more within the moated business. That ratio is the only reason the concept is important and produces two conclusions worth internalizing

Growth is only valuable in proportion to the differential. A company that earns exactly its cost of capital creates exactly zero value as it grows no matter how impressive the earnings graph looks. All it has done is turn cash into a larger version of an average business

And below the cost of capital growth destroys value. Changing Company B's yield to 6 percent and reinvesting billion produces $60 million a year worth about $667 million. The company spent $1 billion to create two-thirds of a billion. Every dollar of expansion made its owners poorer and the income statement would show that revenues and profits were increasing all the time

These are illustrative figures that use a perpetuity assumption for simplicity. The relationship does not depend on that: the value of growth increases with the difference between the yield and the cost of capital and a moat is simply the mechanism that prevents that difference from closing

Moats and Pricing Power

The clearest evidence of a moat is pricing power the ability to raise prices without losing customers. Buffett has said that the most important factor in evaluating a business is pricing power and that if you have to hold a prayer session before raising prices business is terrible. A company that can raise prices at will year after year is almost certainly behind a real moat. A company that shudders at the thought afraid that customers will flee.toward a rival you're telling them that their moat is thin no matter how good their current margins seem

Case Study: Kodak Invented the Thing That Killed It

Every discussion of eroding moats mentions Kodak. Almost none of them mention the detail that makes it genuinely instructive which is that Kodak was not taken by surprise

At its peak Kodak had one of the most comprehensive moats ever assembled. By the mid-1970s it accounted for about 90 percent of American film sales and 85 percent of camera sales. It combined a well-known brand patents on film chemistry a huge manufacturing scale and a distribution network in every drugstore in the country. Four of the five moat sources from the previous section simultaneously

The economy was a razors-and-knives model. Cameras were sold cheaply and films were repeatedly sold at very high margins a structure that competitors found almost impossible to attack

In 1975 a Kodak engineer named Steven Sasson built the first digital camera. It was a prototype weighing several kilograms recorded on a cassette tape and took twenty-three seconds to capture a black and white image. Kodak owned it patented aspects of the technology and understood what it was all about

The company did not miss digital photography. It calculated correctly for several years that digital imaging would destroy the film business that produced almost all of its profits. So it managed the technology cautiously protecting the flow of margin and continued to earn extraordinary returns on film for another two decades while the substitute matured elsewhere

Kodak filed for Chapter 11 bankruptcy protection in January 2012

The lesson is an uncomfortable one for anyone who likes the moat framework. Kodak's moat-protected film. It did not protect Kodak because the threat did not attack the moat but rather made the castle irrelevant. A company that advocates high returns in a disappearing category behaves rationally until the category disappears

Blockbuster is the compressed version of the same story. Its moat was physical scale thousands of stores close to where people lived and that scale was really difficult to replicate. In 2000 it turned down the opportunity to buy Netflix for $50 million. Netflix was not attacking the store network. It was eliminating the reason for having one. Blockbuster declared bankruptcy in 2010

The practical implication is that the useful question is not how wide this moat is. It's what would have to change for this moat to stop mattering which is a completely different analysis and one that almost no one performs on their favorite companies

Moats Erode

A moat is never permanent and assuming it is has bankrupted many investors. Technology regulation and changing customer habits erode moats over time. The Kodak brand Blockbuster's scale and Nokia's distribution were genuine formidable advantages that evaporated within a decade once the ground shifted beneath their feet. The analyst's job is not just to spot a moat but to judge whether it is widening or narrowing which is often the difference.between a great long-term investment and a classic value trap

Where Moat Analysis Goes Wrong

The framework is really useful and has four failure modes that are rarely mentioned by its enthusiasts

The pits are identified backwards. Any company with a long history of high returns can later be equipped with a moat narrative and the narrative always sounds compelling because the returns are there. The test that would make the concept scientific predicting which currently ordinary companies will earn high returns is a test in which the framework works much less well than its retrospective examples suggest

High returns on capital are partly an accounting artifact. Return on invested capital divides earnings by equity on the balance sheet. Research software development and branding are expensed rather than capitalized so companies whose real assets are intangible show almost no capital invested and therefore earn huge returns. That's exactly the category of business most often called a wide moat. Part of the differential in the worked example above is genuine competitive advantage and part of it is where accounting places spending

Durable is unforgeable in advance. The definition requires an advantage to persist and persistence can only be observed after the fact. Meanwhile the word works a lot in investment arguments without having any verifiable content

The framework invites you to pay any price. If a business is truly wonderful and truly durable no multiple seems too high which is the reasoning that produced the Nifty Fifty and cost investors twenty-five years of profitability in excellent companies. Quality and price are separate issues and moat analysis quietly encourages merging them into one

My view is that the concept is the right lens and a bad conclusion and that the most valuable version of it is the question of erosion rather than identification

How I Actually Test for a Moat

When trying to decide if a company really has one I try to avoid the narrative entirely and consider four things

The first is the return on invested capital over a full decade rather than one good year with the underlying cost of capital. The spread in the example above sustained during a recession is the only direct evidence that a moat exists. One or two strong years is a cycle

Second I look at what happened to margins the last time a serious competitor came in. That's the only real experiment available and companies rarely volunteer the result. A company whose margins didn't budge when a well-funded rival came in has proven something no strategy can do

Third I apply the pricing power test literally finding actual price increases in the presentations or the products themselves and checking what happened to the volume. Buffett's prayer session line is memorable because it is a behavioral test that can be observed from the outside

Fourth and this is the Kodak question I try to note what would make the advantage irrelevant rather than merely weaker. Competitors attacking a moat is a normal case and can be survived. A change that eliminates the need for the product is one that kills companies and never shows up in a competitive analysis of the existing industry

That's how I approach it as a description of the method rather than investment advice on any company mentioned here

Why It Matters for the Role

Understanding what makes a company truly difficult to compete with is the foundation of both strategy and valuation. Whether you are evaluating an investment evaluating a new market to enter or evaluating a competitor the first real question is always the same. How durable is the advantage?Is it scaling up or down? Get that judgment right and most of the rest of the analysis will fall into place. Get it wrong and no spreadsheet will save you

The Bottom Line

A moat is anything that prevents the competition from doing what it is supposed to do which is competing for high returns. There are five real sources: network effects switching costs cost advantages intangibles and efficient scale and the broadest examples combine several which is why Visa has operating margins above 60 percent decades after anyone would have tried to copy it

The arithmetic explains why it matters a lot more than it seems. A company that earns 35 percent on capital against a cost of capital of 9 percent creates about $2.9 billion of value by reinvesting billion. A company that earns 10 percent creates about $100 million on the same investment about twenty-nine percent and at 6 percent it destroys value while reporting growing revenue and profits all the time

Kodak is the reason for holding this conclusion broadly. It owned about 90 percent of American film sales invented the digital camera in 1975 understood exactly what it meant protected the film margins that paid for everything and declared bankruptcy in 2012. The question worth asking is not how wide the moat is. It's what would make the moat no longer matter