The Great Moat Debate of 2018

21 May 2018 | by Todd Wenning, CFA

In recent months, there’s been heightened debate over the term “economic moat.” The peak came during the first week in May, when during the Tesla earnings call on May 2nd, Elon Musk commented:

“First of all, I think moats are lame…They are like nice in a sort of quaint, vestigial way. But if your only defense against invading armies is a moat, you will not last long. What matters is the pace of innovation. That is the fundamental determinant of competitiveness.”

A few days later at the Berkshire Hathaway annual meeting, Warren Buffett – who coined the term “economic moat” – responded to a question on Elon’s comments:

“The pace of innovation accelerated in recent years. There are more moats susceptible to innovation than earlier, but folks always attempt to do it. You have to always work to improve and defend your moat. Elon may turn things upside down in some areas, I don’t think he’d want to take us on in candy. There are some pretty good moats around.”

Pass the popcorn. This is about as exciting as news gets for moat-focused investors like us.

A moat by any other name

It’s true that some companies have relied too heavily on legacy moats and have not innovated enough. This is especially true in the consumer-packaged goods industry, where blue chips like Procter & Gamble and Campbell’s Soup became complacent and their moats shrunk. Consequently, it’s easy to point to failed “defensive” moats right now.

Yet we caution against taking the moat analogy too literally. Yes, medieval castle moats were rendered obsolete as a defensive measure by technology (cannon), but the business analogy remains relevant.

Indeed, you can call a “durable competitive advantage” whatever you’d like, but ultimately companies are all after the same thing: winning. (Or at least, they should be.)

And what does winning look like? To us, that means sustainable high returns on invested capital (ROIC). It’s the ability to consistently invest $1 and get $1.40, $1.50, or even $2 back while your competitors either can’t figure out how you do it or simply can’t match you. What prevents companies from chipping away at your ROIC is what keeps you winning – and that’s what moat analysis measures.

Even more importantly, we like companies that are winning by a wider margin. They’re getting better each day. They’re delighting more customers each day. They’re hiring more talented individuals every day. Or as Buffett might put it, they’re “widening the moat.”

Innovation is a critical part of this process. If companies don’t improve, their competitors will. If companies are unwilling to change, their competitors will eventually force them to change.

Bottom line

As investors, our job is to adapt and evolve our process while holding onto core principles. We continue to believe a moat-based framework is the best method for evaluating business quality, yet we agree that moat analysis is changing. As the economy shifts toward intangible assets (i.e., ideas, culture, know-how, etc.) and becomes less capital intensive, the type of analysis that worked in the past will not apply in the future.

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