Economic Moats: Castles aren’t the only things that need them

Throughout history, whether African, Asian, or American, historians are able to give a multitude of examples for the famous defense tool known as a “moat”. Although as old as ancient Egypt itself, the moat, as we know it, comes from the medieval era: circa the 5^th to 15^th century. It’s a deep ditch, sometimes empty, but most frequently filled with water that surrounds a building or structure. Its main purpose is protection from enemies. For castles, this was a barrier to entry. It prevented siege towers, infantry, and other weaponry from getting too close to the castle walls and penetrating the hold. In fact, before any weapons, men, or shielding was used the moat was the first line and most fundamental defense mechanism. It was part of the elementary structure and design of the castle. Just like a castle, a good business has a moat, and I love businesses with strong and wide moats.

When I invest my money I look for companies that have a competitive advantage and ones that are durable. An economic moat fosters both of these features. If a company, for example, has a patent, they are able to create a product or service that no one else can. The competitors are bound by the law to not enter the industry with the same product or service. This is a barrier to entry. This is a moat. And most importantly, because no one else can produce this product, my investment is has an advantage: A competitive advantage. Similarly, as taught in many introductory economics classes, various farmers have an advantage in producing different types of food. This could be as a result of weather conditions, soil irrigation or even technology. But whatever the case, they are advantaged in producing this product and therefore can trade with other farmers for something that they aren’t as good at making in order to increase the total social welfare. These advantages that the farmers have are moats. Mind you, I should state that I’m making no testimony to the strength of this moat, but more so that it simply exists: Another peach farmer can’t compete if he doesn’t have the right soil to grow trees and reap the succulent fruit. All pun intended, some moats can even erode, but this is a subject for a different post.

Moats also provide durability and longevity. If a company has a strong and wide moat, then an investor can assume that this firm is relatively safe from competitors entering the industry and eroding away the profits. With that sort of security, as long as it is a good business model, the moat can provide security to the investor in the durability of the company. An investor can feel safe that the firm will continue for a reasonable amount of time because competitors cannot enter to destroy it. The interesting part of durability in a company is that it seems as though investors ignore it. The greater investment community seems to focus on the company’s product and the short run earnings. But moats have value. They guarantee, for lack of a better word, a future cash flow, and therefore they are worth something. In fact, to loosely gauge how much a moat is worth, an investor can use a DCF model to find the present value of the future cash flow and expect that the bulk of the terminal value be as a result of the moat. This is because the moat creates durability and the durability creates going concern, an investment term for indefinite life. To explain this better, think about automobiles. At the time of writing thing post Toyota has an incredible reputation for the durability of their cars. So when you buy a Toyota product you know that a portion of the cost that you pay is as a result of the fact that the car is well made and will last – durability.

If you’re a new investor or new to value investing, moats should be your best friends. There are many reasons for this but primarily; they’ll help you stay on target. I don’t see speculative investments that are durable. I’ve don’t see such investments with a competitive advantage. It’s that value investments that have strong moats. So investing according to moats will help you stay disciplined and in line with the value paradigm. Because moats are a barrier to entry, you’ll see that the threat of competitors is low and so, your capital won’t be eroded or impaired away significantly as a result of competition. This makes the business resilient. Such resilience gives the firm an opportunity to experiment and innovate. Innovation means growth. This is growth in the business and growth in your invested capital. The concept of innovation fostering genuine and organic growth is a subject for a different post but one thing that can be said here is that this success can be measured using the Return-on-Capital metric: how much return the firm is making on the capital that you, the investor, put into it. You’ll see that companies with a moat, barring any special cases, typically have a fairly reasonable return-on-capital (ROC).