Company Moat: Durable Competitive Advantage
Warren Buffett’s Four M’s of investing are Meaning, Moat, Management and Margin of Safety. As we think about a company’s moat, we’re thinking about the competitive advantage the company has within its industry. The company moat is similar to how a moat protects a castle, but in this case we’re talking about the ‘how’ of what a company does and how that moat makes the company desirably different from other companies within that industry. We want the moat to be durable and ingrained into what the company does, so it can protect the company over the long term.
Think about why customers buy this company’s product. Is because it’s a better quality? A lower price? It’s the only provider of the service in the area? That ‘why’ is the company’s moat. There are several types of moats including brand, toll bridge, price, secrets, and switching. Here is a short video of Warren Buffett discussing the importance of a company’s moat.
Brand Moat
A brand moat is a company moat based on the company’s name, image and the associated perception of quality. A good example of a strong brand moat is Coca Cola. People who like Coke have loyalty to that brand of cola, and they will pay a little more for having that brand vs another. At your child’s birthday party, will you serve Coke or the generic store brand? Most people would rather serve the name brand soda.
Car brands can also have a strong brand moat. A Ferrari has quality and prestige. A Chevy Corvette will get me to my location, while a Ferrari gets me to my location in style while making a statement. A Ferrari and a Corvette are both fast cars that can be fun to drive, but the Ferrari costs many multiples of the Corvette. Ferrari can charge that premium price because of the prestige associated with their brand. That level of commitment a buyer makes when buying a Ferrari is indicative of a strong brand moat.
Price Moat
A company with a price moat is a company that can produce items at a lower cost than other companies. They may not charge the lowest price in the industry, but they could, and still be profitable. A company with a price moat is able to lower their prices beyond that of their competitors and still turn a profit. This means that if there is a price war in their industry, the company with the price moat will win.
Amazon is another example of a company with a price moat. I can buy almost anything I can think of on Amazon, and get it at a lower price than I would pay elsewhere. They’ll even ship it to me. So Amazon’s price moat enables me to save money on the item, and then they ship it to my door. That’s tough to beat.
A good example of a company with a price moat is Walmart. Customers can buy the same item at Walmart versus a different grocery store, but buying it at Walmart means they will pay less for that same item. Whether it’s Kraft Macaroni and Cheese, Tropicana Orange Juice or Johnsonville Brats, the same item consistently costs less at Walmart. Walmart can sell items for less than their competitors because they buy their inventory in such large quantities that they are able get the those items at a much lower price. That can make it difficult for smaller grocery stores to compete with them.
Secrets Moat
A secrets moat is when a company competes using a secret or patent. A good example of a company with a secrets moat is Coca Cola and their secret recipe. Pharmaceutical companies compete using a secrets moat with their ingredients for medications. Restaurants like KFC use a secrets moat for their chicken breading recipe. Google has a secrets moat in how they rank websites for search engine optimization. For companies that compete using a secrets moat, we need to consider how durable that secret is. If it’s a patent, will the patent expire soon, and if so, does the company have another product in its pipeline?
Toll Bridge Moat
A toll bridge is a company moat that requires a significant monetary investment and a process that would be difficult for another company to copy, even if they had the resources to make a similar sized investment. If I have capital equal to the market cap of a company, could I crate another company that could compete with the first company? If not, the first company may have a toll bridge moat.
A good example of a company with a toll bridge moat is a railroad. Even if a company had the money to invest in building railroad track, it would be incredibly difficult to get enough continuous land to make a new line of track from the East coast to the West coast. That means that for railroads to grow their track miles, they need to acquire another railroad. Another example of a company with a toll bridge moat is UPS. UPS has drop off locations, shipping centers, air planes, vans, delivery trucks, semi-trucks and thousands of employees. A company with the amount of money it would take to replicate the assets of UPS would still have a difficult time creating another UPS. That difficulty is the toll bridge moat.
Switching Moat
A switching moat is when a company has a product the customer learns to use, and if the customer switches to a competing product they will need to go through that learning curve again. At the consumer level a good example is an Iphone vs an Android. Or Mac vs PC. At the company level an example is a software developer that sells software to companies. If I run a large company and we decide to make a computer program change, that’s a big shift that could take millions of dollars and a significant time investment to transition. It will also likely be a major headache operationally. That cost of making the change is the switching moat.
Another component of the switching moat is the number of users on the platform, and if I switch to a different provider, the user base is not large enough for the same experience. An example of that would be Facebook. Facebook works because so many people use it. Without the large number of users, the service doesn’t have the same effect. Another company trying to replicate Facebook’s service would have a difficult time getting as many people on their platform. That means the new platform would not provide the same service level as the established platform, so users are less likely to make the switch. That’s a switching moat.