Warren Buffett on Economic Moats 6


 

Warren Buffett consistently emphasises that he wants to buy businesses with prospects for sustainable value creation. He suggests that buying a business is like buying a castle surrounded by a moat and that he wants the moat to be deep and wide to fend off all competition. Economic moats are almost never stable. Because of competition, they are getting a little bit wider or narrower every day.

Companies and investors use competitive strategy analysis for two very different purposes. Companies try to generate returns above the cost of capital, while investors try to anticipate revisions in expectations for financial performance. If a company’s share price already captures its prospects for sustainable value creation, investors should expect to earn a risk-adjusted market return.

So what exactly does Warren buffets mean by economic moat?

What most people call competitive advantage, Buffet refers to a a “moat”.
A competitive advantage is an advantage a business has over its competitors by offering consumers greater value, either by means of lower prices or by providing greater benefits and service that justifies higher prices.

Michael Porter identifies two basic types of competitive advantage:

  • Cost advantage. (Be the lowest cost producer in an industry)
  • A Differentiation Advantage. (Offer products that are different and add value than the norm in the industry)

A competitive advantage exists when the firm is able to deliver the same benefits as competitors but at a lower cost (cost advantage), or deliver benefits that exceed those of competing products (differentiation advantage). Thus, a competitive advantage enables the firm to create superior value for its competitors and superior profits for itself.

 

What Warren Buffet has to say about competitive advantage:

What we refer to as a “moat” is what other people might call competitive advantage . . . It’s something that differentiates the company from its nearest competitors – either in service or low cost or taste or
some other perceived virtue that the product possesses in the mind of the consumer versus the next best
alternative . . . There are various kinds of moats. All economic moats are either widening or narrowing –
even though you can’t see it.

Outstanding Investor Digest, June 30, 1993

Look for the durability of the franchise. The most important thing to me is figuring out how big a moat
there is around the business. What I love, of course, is a big castle and a big moat with piranhas and
crocodiles.

Linda Grant, “Striking Out at Wall Street,” U.S. News & World Report, June 12, 1994

The key to investing is not assessing how much an industry is going to affect society, or how much it will
grow, but rather determining the competitive advantage of any given company and, above all, the
durability of that advantage. The products or services that have wide, sustainable moats around them are
the ones that deliver rewards to investors.

Warren Buffett and Carol Loomis, “Mr. Buffett on the Stock Market,”
Fortune, November 22, 1999

We think of every business as an economic castle. And castles are subject to marauders. And in
capitalism, with any castle . . . you have to expect . . . that millions of people out there . . . are thinking
about ways to take your castle away.
Then the question is, “What kind of moat do you have around that castle that protects it?”

Outstanding Investor Digest, December 18, 2000

When our long-term competitive position improves . . . we describe the phenomenon as “widening the
moat.” And doing that is essential if we are to have the kind of business we want a decade or two from
now. We always, of course, hope to earn more money in the short-term. But when short-term and longterm
conflict, widening the moat must take precedence.

Berkshire Hathaway Letter to Shareholders, 2005.

A truly great business must have an enduring “moat” that protects excellent returns on invested capital.
The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that
is earning high returns . . . Our criterion of “enduring” causes us to rule out companies in industries prone
to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society,
it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at
all . . . Additionally, this criterion eliminates the business whose success depends on having a great
manager.

Berkshire Hathaway Letter to Shareholders, 2007.

 

I hope this post has helped you in understanding the power of competitive advantage. Next time you decide to invest in a company, be like Buffet and selects companies with a durable competitive advantage, or, as he puts it, “economic castles protected by unbreachable ‘moats’”. As the great man says “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”.

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