Measuring The Moat: A Guide To Value Creation
The following is a summary on “Measuring the Moat” published by Counterpoint Global Insights — a division of Morgan Stanely focused on Active Fundamental Equities and authored by Michael J. Mauboussin, and Dan Callahan, CFA.
The original piece is long-form and quite comprehensive. While we still encourage you to read the full article in its entirety, I decided to compress it into something a bit more digestible. Therefore, the goal of this piece is to provide some key takeaways and insights into what it means to build an enduring company for both founders and investors.
Let’s dive in.
In a world of competitive business and long-term investing, one concept frequently comes up as a defining feature of a strong, enduring company: the moat.
Coined by Warren Buffett, a moat basically represents a business's competitive advantage that shields it from the competition, allowing it to generate consistent returns that outpace its costs, including opportunity costs and capital costs.
For founders and investors, understanding and establishing a company's moat is essential to ensure sustainable value creation.
This article dives into what a moat is, the types of moats that companies can leverage, and how to build one that genuinely contributes to a company's long-term growth and profitability.
What is a Moat?
A moat, or sustainable value proposition, is a unique advantage that enables a company to consistently achieve Returns On Invested Capital (ROIC) exceeding its Weighted Average Cost of Capital (WACC). This means the company generates more value than it consumes, building a buffer against competitors who may want to replicate its success. The moat is, therefore, a critical component for companies aiming to create long-lasting value and resilience in the face of market competition.
Measuring a Moat's Strength
The strength of a moat can be assessed by the spread between ROIC and WACC, observed over time. The larger and more sustainable this spread, the more robust the moat. A company with a wide moat can reliably generate higher returns, while a narrow moat suggests susceptibility to competitive pressures.
Types of Moats and How to Build Them
A strong, defensible moat can arise from different sources. Below are the primary categories of moats that companies can take advantage of:
1. Cost Advantage
Why It Matters: Companies who find ways to lower their production or operational costs can underprice competitors while maintaining healthy profit margins.
How to Build: Achieving cost advantage often involves economies of scale, streamlined production, advanced supply chain management, and efficient resource use. For example, Amazon leverages economies of scale to offer competitive prices, attracting a massive customer base.
2. Network Effects
Why It Matters: As more users adopt a product, its value increases, creating a self-reinforcing cycle that strengthens customer loyalty.
How to Build: Platforms like social media, marketplaces, and collaborative software can benefit from network effects, as seen with Facebook and LinkedIn. By encouraging user-generated content, these platforms increase their appeal to new users as existing users add value.
3. Brand Loyalty
Why It Matters: Strong brands increase customer willingness to pay and reduce customer sensitivity to competitors’ offerings, effectively creating a barrier.
How to Build: Cultivating brand loyalty involves building trust and emotional resonance with consumers. Brands like Apple and Coca-Cola have successfully created emotional connections, elevating their perceived value.
4. Switching Costs
Why It Matters: Products with high switching costs deter customers from seeking alternatives, as the time, money, or resources needed to switch become significant barriers.
How to Build: B2B software providers like Salesforce and SAP employ complex, integrated systems that would be costly and time-consuming for businesses to replace, making switching unattractive and prohibitively expensive.
5. Intellectual Property (IP)
Why It Matters: Patents, trademarks, and proprietary technology prevent competitors from directly copying products or services, offering a legal shield.
How to Build: Protecting proprietary innovations through patents or copyrights helps companies like pharmaceutical firms maintain exclusivity and price control over their drugs for years.
Analyzing Industry Structure
Industry structure is a core element in determining a company’s potential to build and sustain a moat.
Michael Porter’s Five Forces framework helps founders and investors understand the competitive landscape and identify areas where a company can build a competitive edge.
Rivalry Among Existing Firms: High competition reduces profitability.
Threat of New Entrants: Industries with low barriers to entry face constant threats from new players.
Threat of Substitutes: Substitute products can cap a company's pricing power.
Bargaining Power of Buyers: Strong buyer power forces companies to lower prices.
Bargaining Power of Suppliers: Supplier power impacts production costs.
For instance, the airline industry has low barriers to entry and high buyer bargaining power, limiting its attractiveness and making it difficult to establish a sustainable moat.
Building Sustainable Value Creation through Moats
Value creation stems from the ability to offer a product or service that customers perceive as superior to alternatives.
This can be achieved by increasing customer Willingness to Pay (WTP) and/or lowering supplier Willingness to Sell (WTS), creating more profit margin per unit — the bigger the gap, the better.
1. Increasing Willingness to Pay (WTP)
Approach: Differentiate the product through unique features, status appeal, or ease of use.
Example: Tesla has leveraged product differentiation through innovation in building super reliable electric vehicles, tapping into customers’ willingness to pay for sustainable, high-performance cars.
2. Lowering Willingness to Sell (WTS)
Approach: Reduce costs or enhance productivity to improve margins without raising prices.
Example: Walmart’s streamlined logistics and bulk purchasing allow it to maintain a low cost of sales, enabling lower prices that drive customer loyalty.
Checklist for Sustainable Value Creation
In general, you can evaluate a company's moat potential by asking some questions:
Industry Analysis
Have you identified the profit pool for this industry?
How concentrated is the market?
Is concentration stable or changing?
What are the barriers to entry for this industry?
Are there network effects, licensing barriers, or significant economies of scale?
Company-Specific Factors
Is the company's value chain optimized?
Are there differentiators that increase WTP, such as superior design or unique technology?
Does the brand encourage loyalty or convey status?
Do the company’s products provide prestige, promote habit, or lower search costs?
Is there lock-in that creates switching costs? If so, what type of lock-in is it?
Are there strategies in place to lower WTS, like productive workforce relations or efficient cost structures?
Final Thoughts
In the pursuit of sustainable value creation, a company’s moat becomes its defining feature, providing resilience and competitive longevity.
Founders should consider which type of moat aligns best with their industry and business model and invest deliberately in strategies that build and protect it.
Investors, on the other hand, can assess moats by analyzing a company’s ROIC, industry structure, and strategic positioning.
Together, these insights offer a roadmap to achieving and recognizing sustainable value, allowing both founders and investors to cultivate or support businesses with true long-term potential.
By recognizing the importance of moats, founders and investors can better align their goals and make choices that result in durable success and sustainable value creation.
