Not too long ago, lords and ladies used to build castles and dig deep moats around them to protect their wealth and well-being from intruders. Today, luckily, people do not have to fear for their lives like in the old days, but businesses still do. Companies in a capitalistic society live in a cut-throat environment, where, if you happen to find a business niche that is exceptionally profitable, competition will come for you.
Our guy Warren Buffett loves exceptionally profitable businesses, but he also hates having these profits being taken away by competition. Therefore, Buffett insists that having a moat around the business castle is perhaps the most important criterion of all when investing in stock market companies. And he is not looking for small ponds either, these moats should be as wide as possible.
We think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And to our managers we say that we want the moat widened every year. In this video, you’ll learn how to identify companies that can remain profitable in the long run, perhaps one of the most important skills that a value investor can possess.
This is the Swedish Investor, bringing you the best tips and tools for reaching financial freedom, through stock market investing. First and foremost - What is a moat? Just in case you haven’t had enough of the metaphors yet, here’s a final one.
Having an exceptionally profitable business is a little like having an exceptionally attractive partner. You know, there will be competition for such things. In both cases, if you want to remain in your unusually favourable position, you’ll need a sustainable competitive advantage.
That’s a mouthful, but this is exactly what Warren Buffett means with a moat, so let’s break it down. “In business, a competitive advantage is the attribute that allows an organization to outperform its competitors” (Wikipedia). Overperformance should be measured against competitors in the same industry, and against businesses in general, and usually means: - Higher profitability - Higher return on capital; and/or - Large market share To identify a competitive advantage, you can use a financial data provider such as TIKR and look at the historical numbers.
I’ll show you how to do this quickly and for free by the end of this video. Then we have sustainable. This is the dark art of investing, the sort of thing that makes it so that it is not necessarily academics with great mathematical skills that become the best investors.
Because the durability of a moat is very difficult to measure in numbers. There’s no formula that gives you that precisely, you know, that says that the moat is 28 feet wide and 16 feet deep, you know, or anything of the sort. You have to understand the businesses.
Because a moat isn’t measurable so easily, people aren’t that great at identifying them. And in investing, when the herd is having trouble with something … Do you smell that? What’s that smell?
Opportunity. The Key Question to Identify Moats You know, every time I look at a business — when we bought See’s Candy in 1972, I said to myself, if I had a hundred million dollars and I wanted to go in and take on See’s Candy, could I do it? And I came to the conclusion, no, so we bought See’s Candy.
Buffett has a similar quote about taking over Coca-Cola’s position as the leading soft drink company but this time with $100 billion. His conclusion is the same: it can’t be done. Whenever it is impossible to dethrone a business earning $7-10 billion per year even with $100 billion, you know that the said business possesses a very wide moat.
Entrepreneurs with a knack for expected value won’t even bother competing in these types of scenarios, and those who stubbornly try nonetheless will bleed. However, remember that answering this question is an art, not a science. The quickest way to understanding the art is probably to observe a few of Warren Buffett’s most important investments.
The Business Moats of Berkshire Hathaway If you can place yourself in the shoes of a customer of a company, chances are that you’ll understand if that business has a moat or not. Let me give you a few examples. Coca-Cola has been the leading soft drink in the world for a very long period of time.
Almost 2 billion servings of Coca-Cola company drinks are consumed each day. And it hasn’t achieved this market penetration at the expense of profitability either. What is it that makes Coke so special?
Collectively, Warren Buffett refers to Coke’s moat as “share of mind”. What he means by this is that in billions of peoples’ minds, all over the world, there’s something favourable associated with the brand name Coca-Cola. It means something to them, probably “refreshment” or “happiness” or something along those lines.
And any time a customer would like to feel refreshed, there’s a Coke within an arm’s length, thanks to the company’s incredible distribution system, which is a moat, too. The company wants its customers to continue their habit of drinking Coke, and they should never be forced to choose, say, the Swedish Cuba Cola instead, because there wasn’t a Coke nearby. These are the things that make Coke’s competitive advantage sustainable, and it will most likely be around in 20 or 30 years too.
Another company with a huge moat is Apple, which currently is Buffett’s largest public investment by a landslide. Its competitive advantage is like Coke in that it has a strong brand name and a positive “share of mind”, but there are two other things that I’d like to point out too. The first is that Apple has important network effects in place.
What this means is that the more people that join the Apple community, the more valuable it becomes. The more people that use iPhones, the more app developers want to produce products for the App Store, the more people will use iPhones, and round and round it goes. Secondly, there are technical lock-in effects.
This may not be as important as the beforementioned reasons, but seriously, I’m so confused every time I’m asked to navigate a phone that is running on Android. Even if a Samsung sells for $200 less than a similar iPhone, I just can’t be bothered with switching as it would mean that I’d have to relearn how to navigate the phone, and I’d probably face some problems transferring my data too. Most likely, I’m going to continue to buy iPhones in the foreseeable future too.
Then we have BNSF, one of two of the really large railway companies in North America. If your company needs to move large loads over longer distances, and you are price-sensitive to transportation costs, you are going to choose railway, and you don’t have too many options here. Why?
Because it would take an incredible amount of capital and time, not to mention confirmations from local authorities, to build a railway network similar to that of BNSF’s. You don’t just put up a second railroad next to the first one, in many cases there probably isn’t even space for that. Therefore, it is very difficult to replace BNSF’s profitable business.
See’s Candy is Warren Buffett’s 3rd most important investment ever. For a 100% ownership in this premium chocolate producers, he spent roughly 40% of his net worth in the 1970s. That’s a huge bet, and it also paid off.
See’s has a similar share of mind advantage as Coke, but only locally in California. However, there’s another advantage which is quite different from Coke’s. Its premium chocolate is purchased very seldom, and only for special occasions.
When you buy premium chocolate once a year for your loved ones, say, for Valentine’s Day, will you pick the recognized premium brand, or will you save $10 to pick the new, cheaper option? Ahh … the three words that every girl wants to hear. Then we have GEICO, the 2nd largest auto insurance company in the U.
S. , which also happens to be Buffett’s most successful investment of all time. I think it’s fair to say that the 33% stake in the company that he purchased during 1976-1980 has been almost a 1000-bagger for Berkshire, which is completely nuts.
Anyway, the reason why GEICO has a sustainable competitive advantage is because it is the low-cost choice in an industry where price is important to customers, auto insurance is a pretty damn big expense for most households. Being the low-cost producer in a commodity business is powerful. And thanks to the fact that GEICO seems to become more and more cost efficient as it continues to grow, this should be an advantage that is sustainable too.
All Moats Are Not Created Equal Easy come, easy go. If you look at the businesses that were just mentioned, you’ll probably see a common theme. They’ve been in the game for a while.
In December 2020, the FTC sued Facebook for “illegal monopolization”, basically stating that the company has enjoyed a position in the social media business which has been too dominant for too long. A monopoly is of course the strongest moat that one can have, but with the benefit of hindsight, I think it’s fair to say that such worries were a bit eccentric. Seeing how a company like TikTok can become a force to be reckoned with in such a short period of time I think the jury is still out on whoever will continue to be the dominant player in social media.
Facebook does have a strong position in the industry, but if someone asks me to bet if Ithink that, 30 years from now, is more likely that Coke will have a dominant position in soft drinks or that Meta will be dominant in social media, I’d bet my money on Coke. And judging by Warren Buffett’s investments, he is of a similar opinion. Usually if something can gain competitive advantage very quickly, you have to worry about them losing it quickly, too.
I mean, when an industry is in flux, there are a lot of people that think they’re the survivors or the ones that are going to prosper, where it turns out otherwise. And yea, the businesses of Coke, BNSF, See’s Candy and GEICO practically haven’t changed much in 100 years. Apple is of course, kind of an exception, as its real success has come quite recently, so you can’t always say that longer is better, but it’s still a powerful rule of thumb.
Intelligent investors should stop chasing the latest trends. Old is gold. Finding Businesses with Moats Quickly Now you may ask yourself – well, where do I start?
Where should I go and look for moats? I said earlier that the sustainable part is quite difficult to evaluate. You’ve just learned a few tricks for doing it, but nothing can replace individual business and industry knowledge.
However, to see if a business has a competitive advantage right now isn’t so tough, and this is a great place to start. We tend to judge by the past record. By and large, if the thing has a lousy past record and a bright future we’re going to miss the opportunity.
For this, I would suggest that you head over to a financial data provider, and my favourite one is TIKR. You can create a free account by signing up with the link in the description, tikr. com/tsi and then you can use their screening tool which will help you in identifying moats.
I’ve used TIKR in my own stock market research for more than 1. 5 years now, and I think it provides the best value for long-term investors. Use the screener that I’ve created here, it should work from any free account.
It will save you time in your investment process by filtering out companies with a clear competitive advantage. So, if you want to go on an adventure and identify impregnable castles of your own, head over to tikr. com/tsi.
If you feel that you’re not quite ready yet, then you should check out my video on Warren Buffett’s 25 most important investments of all time. It’s filled with awesome moats. Cheers guys!
