What’s an Economic Moat ?

Why is it important and can one estimate it ?

[Most of this discussion is derived from Mauboussin and Callahan paper « Measuring the Moat » and other documents from Morningstar, where I work]

Economic Moat is a very important factor for successful investment. If you find a company that has an economic moat and if you can grab a share of its business with a significant margin of safety, you’re pretty sure to make a good investment over the long run.

Warren E. Buffett, the most successful investor of all times, has been one of the first known person to talk about the importance of this concept. In 1994, he is quoted for having said : « The most important thing to me is figuring out how big a moat there is around the business. What I love, of course, if a big castle and a big moat with piranhas and crocodiles. » (he mentioned the « moat » idea earlier in the 1986 annual letter to the shareholders of Berkshire Hathaway).

What is a Moat ?

For a company, a moat is a sustainable competitive advantage that results in return on investments that exceeds the cost of capital and the average of the industry they compete in.

Moat can be a key driver of excess return for a company and its shareholders and results in the growth of a firm’s value. It can also at times explain the premium a company trades at compared to the market and its peers, although « moaty » companies can also trade at a discount.

If you look up the companies researched by Morningstar, you will find some names that do have moats but are discounted to their fair value estimates. Why is that? Simply because investors all apprehend value differently (when they do) to reflect their different time horizons, risk aversion and specific circumstances (tax…).

Sometimes, for those many reasons and also they can be affected by psychological biases, investors overlook some industries because they lack the characteristics that make them look like good investments compared to over sectors, which are more « in fashion ». You can think of Energy the last couple of years vs Technology for instance.

How does one measure the moat of a company ?

Well it’s a long process… Not only do you have to figure out how a company behaves in a specific industry, but you also have to understand the industry, which means you have to read a lot about it… That’s the reason why some investors prefer to focus on a limited number of industries they will get acquainted with over time, because it takes time…

If you want to know what’s the moat of a company, you actually need to start with an analysis of the industry. A number of tools might be of help, including the famous 5 forces matrix from Michael Porter.

Key steps for the industry analysis

– Determine an industry map (key players and relationships with stakeholders – employees/unions, regulator, suppliers, customers, distribution…);

– Establish a profit pool by activity. There you look at sales/invesments (x-axis) and return on invested capital (y-axis) for each activity, and also at average return on invested capital over 3 to 5 years. This will help determine if the industry as a whole structurally creates/destroys value and which segments in the industry contribute to value creation.

You need to know if the industry is rather stable (in terms of market share of key players and pricing dynamics) or unstable, meaning that the ability to maintain a competitive advantage is sustainable or not.

Then you can turn to the « Five Forces » framework from Michael Porter, which helps understand « the underpinnings of competition and the root causes of profitability. »

You have to get a sense of how easy it is to get in/out of an industry, how intense competition might be among participants (concentration/fragmentation of the industry), what’s the growth rate of the industry.

You also may want to know if there are risks of disruption, and rely there on the splendid work of Clayton Christensen (Mauboussin & Callahan offer a brief overview of its work).

Company analysis

Once you understand the industry, you can focus on the company. As Mauboussin & Callahan remind us, « a company’s ability to create value is a function of the strategies it pursues, its interaction with competitors, and how it deals with non-competitors. »

Here we try to understand what the added value of the firm and how it generates it. According to previous work from Porter and other academics, the added value sources either from a « production advantage » (cost leadership) or a « consumer advantage » (product differentiation). In the end, the client is willing to pay for a product that’s worth more its production cost for the company.

The key sources of production advantage are : economies of scale (in industry with high fixed costs), complexity of manufacturing processes, technological advances with imply fast cost reduction, protection of intellectual property (patentes, trademarks, copyrights) and the access to specific resources or assets.

Economies of scale can derive from specific advantages in distribution, purchasing/procurement, R&D (economies of scope and the ability to use a product to solve many different problems) and advertising.

Consumer advantage comes from the ability of a product/services to offer a better benefit and cost to the consumer than those of the competition. Among key differentiating factors we find habits, « experience goods » (a product you buy only after you tried it once), switching cost and customer lock-in, network effects.

Government can also have an impact on the added value of a firm, through subsidies, tariffs, quotas and competitive and environmental regulation.

Putting it all together

Per Mauboussin & Callahan : « Stock prices reflect expectations for future financial performance. Accordingly, an investor’s task is to anticipate revisions in those expectations. A firm grasp o f the prospects for value creation is a critical facet of this analysis. But value creation itself is no assurance of superior stock price performance if the market fully anticipates that value creation. »

They offer a 3 step method to see if a stock is a real opportunity, once we better understand the industry, how the company is positioned and how the market prices in or not this information.

  1. Find the price-implied expectations. Basically this means doing a reverse-DCF. This can be tricky since there are many assumptions to consider and probably focusing on a few key metrics (sales growth, margins, capex, tax) can give different results. There it might make sense to have a sensitivity analysis ran as an overlay.
  2. « Identify expectations opportunities », which means see if the consensus will change its perception of the company and start revising its estimates.
  3. Make an investment decision.

« A thorough analysis of a company’s prospects for sustainable value creation is essential. This analysis can then intelli gently inform a fina ncial model to determine whether or not a particular stock offers prospects for superior returns. »

The paper provides a useful list of questions that could fit in an investment checklist, worth using when considering an equity investment