Sustainable Moats and How to Spot Them
“A strong ability to defend established markets against new competitors is essential for a sound investment.” – Philip Fisher
7/25/19 Oleg Litvinenko, CFA
Fisher’s quote above describes what we here at Cobblestone Capital consider a critical factor when investing in businesses. For a business to generate above-average shareholder returns over a number of years, it must possess a competitive advantage, or “moat”, in order to defend its proverbial castle against competition.
While much has already been written about competitive advantages in the academic and business literature, most of them come down to three types: cost advantages, preferential access to customers (brands, intellectual property, switching costs, and regulatory, among others), and scale advantages. Microsoft’s enterprise customers, for example, would incur meaningful switching costs if they were to transition to a new vendor. These barriers in turn make it easier for the company to sell its cloud services to existing clientele. Coca-Cola has been able to capture abnormal returns over decades due to customers’ brand loyalty and habitual, high-frequency purchasing behavior.
While some competitive advantages are sustained over decades, most are fleeting. Once endowed with a strong competitive position, companies often expand in size but fail to focus on strengthening the advantage. As Charlie Munger, Vice Chairman of Berkshire Hathaway, once said, “Old moats are getting filled in and new moats are harder to predict.” The Gillette example is a good case in point. Not too long ago, none other than Warren Buffett was touting the brand’s impenetrable moat. At the time, it was hard to imagine anyone successfully competing with Gillette’s manufacturing prowess and marketing scale. Fast forward to today, and the rise of the internet allowed the likes of Harry’s and Dollar Shave Club to make a meaningful dent in Gillette’s market share as consumers are no longer confined to the tightly guarded store aisle to find good quality shavers.
The sustainability of moats has much to do with the quality of key decision makers. For a business to be able to consistently fend off competition, it has to have an incentive system capable of drawing out entrepreneurial risk-taking and an executive team focused on creating value over the long term. Paul Polman, former CEO of Unilever, for example, has established a culture of decentralization and employee initiative that has made Unilever much more responsive to changing consumer preferences. Mark Leonard, founder and CEO of Constellation Software, delegates responsibility to business unit managers to the point of allowing them to pursue their own M&A. He also purposefully breaks up business units to allow emerging business leaders to reach their full potential.
Spotting and investing in wide moat companies requires both qualitative and quantitative insights. Consistently high and improving returns on incremental capital employed in the business can indicate a strong competitive position. Said differently, an ability to stave off competition vying for attractive profitability over a number of years reflects a favorable competitive position. A stable or rising market share is another sign of an advantage—it shows that customers continued to prefer a company’s products despite attempts by others to dislodge it.
In order to generate attractive value for shareholders over many years, a business must establish and defend a strong competitive position. The sustainability of that position is critical and depends on management’s ability to cultivate a supporting internal culture capable of carrying the business through shifting customer preferences and economic cycles.
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