Elon Musk has added competitive moats to the growing list of things he thinks are lame, but Warren Buffett begs to differ. As the two billionaires challenge each other, we ask the fundamental question: Are moats still important to a high-quality business?

In this episode of Industry Focus: Consumer Goods, Vincent Shen is joined by senior Motley Fool contributor Asit Sharma as they explain what investors need to know about economic moats before pivoting to the candy industry as an example of one business where moats remain as important as ever.

A full transcript follows the video.

This video was recorded on May 8, 2018.

Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Tuesday, May 8th, and I'm your host, Vincent Shen.

Rounding out the cast for today's consumer and retail discussion, we have senior Motley Fool contributor Asit Sharma, who's beaming into the Fool HQ studio via Skype. Hey, Asit! Hope all's well!

Asit Sharma: All is great, Vince! You make that sound so technologically advanced. I almost feel like I'm going to materialize in the studio.

Shen: That would be cool. At some point, maybe, we'll have you hologram into the studio sitting next to me. It'll be a much more fun experience that way, for me, at least.

Sharma: Absolutely.

Shen: I'm going to thank you right off the bat for bringing the main topic of this episode to my attention. I hadn't been following this story as much. Since you brought it up, it's come up in the editorial pod and among some of the other Industry Focus hosts, they've talked about it.

We're reaching outside of the consumer and retail sector just for inspiration to kick off this conversation. Asit, please chime in with any thoughts or color you want to add as we walk through some of the background for the show and the topic today. 

Last week, Tesla (NASDAQ:TSLA) reported its first quarter earnings for 2018. There was, of course, a call with analysts to go over the latest results. During the Q&A portion of that call, company founder and CEO Elon Musk spent a few minutes answering typical Wall Street analyst questions before he eventually lost interest and passed the mic to Galileo Russell, a follower of the company who runs a technology and investing-focused channel on YouTube. 

At one point on the earnings call, Galileo starts asking about Tesla's Supercharger network and why the company is open to collaborating with competitors, in terms of letting competitors into the Supercharger network so they can access Tesla's charging stations. The company's built something like over 1,200 of them around the world. That's some of the context of where these comments begin. I'm going to read you the quotes from the earnings call.

This is from Galileo. He says:

I'm just wondering why that isn't a moat, because as a long-term investor, I feel like the charging infrastructure you guys have built would take years and millions of dollars for another brand to replicate. So I'm just curious about the strategic thinking behind opening that up versus keeping it closed.

And Musk responds:

First of all, I think moats are lame. I mean, they're like nice and sort of quaint in a 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's a fundamental determinant of competitiveness.

Lots of Elon Musk fans and Tesla investors here at the Fool, but at the same time, we have lots of fans and followers of the person who coined the idea of a competitive or economic moat, and that's the legendary Warren Buffett.

As it turns out, the annual Berkshire Hathaway annual meeting took place last weekend, too. At that event, Musk's comments on moats came up, so Buffett actually responded. He said, "Certainly you should be working on improving your own moat and defending your own moat all the time. And Elon may turn things upside down in some areas. I don't think he'd want to take us on in candy."

If you're wondering why candy entered the conversation, it's because See's Candies is part of the Berkshire Hathaway portfolio. They acquired that company, I think, almost 50 years ago. And Buffett has mentioned multiple times before how See's is very successful thanks in part to the moat it has from a very strong brand, very loyal customers. 

Musk ends up making some tongue-in-cheek announcements on Twitter that he's going to start a candy company to answer Buffett's challenge. I'm not going to pay too much attention to some of the shenanigans that come up in social media. That story ultimately leads us nicely to our main discussion for today, where we'll first take a closer look at the concept of an economic moat before using the candy industry itself to illustrate how wide some moats can still be, even in a time when we think about innovation and disruption taking place across all industries. 

Break it down for us, Asit. The moat terminology has been around for 20 years. The concept itself, I think, even longer than that. What's the core idea behind a moat, and why does Buffett really prioritize it when he evaluates a business?

Sharma: First of all, Vince, it's a lovely visual and easy metaphor to grasp, the idea that your castle has one barrier, the last line of defense, which is the stream of water which can be quite wide, or it can be narrow. It's very easy to translate that into economics. An economic moat is a competitive advantage or series of advantages that allows a company to earn outsized profits over time.

Basically, over the years, these have fallen into just a few categories, and I'll list a few for our listeners. Creating real or perceived product differentiation is said to be an economic moat. Think of the Big Mac. That was a very different product back decades ago when it was first introduced. It created a lot of differentiation in that fast food burger marketplace. Second, having low cost, being the low-cost leader. Before Amazon started ramping up several years ago, Walmartfor decades, had an advantage as a low-cost retail leader. 

Locking in customers by creating high switching costs. A great example of this is Gillette. You often hear about the razor and blade model, and how great it is when a customer buys a razor, then they're locked into buying a company's blades. Gillette enjoyed this advantage. Once you invest in that razor, you don't want to spend, in today's dollars, another $15 to $20, for the competitor's razor. You're stuck with the blades, because your investment is sunk. We might return to this if we have time this episode, because that model, there's a great example of disruption in Dollar Shave Club

And finally, locking out competitors by creating high barriers to entry. For me, I think Apple is a great example of this, because the iPhone was a blend of functionality, brand cachet, really high technology when it was first introduced. That produced a sustainable competitive moat for Apple for several years.

These are the big categories, illustrations of what creates what Buffett thinks of as an economic moat. I just wanted to refer listeners, I used a condensed summary from Morningstar. There's so much on moats, and we at The Motley Fool write about this. These few bullet points, I grabbed them from Morningstar. They've built a business around economic moats. It's one of the criteria Morningstar uses to evaluate stocks. Very few companies that I like outside The Motley Fool that help investors, but Morningstar is pretty good.

Shen: OK. I will say, personally, I like looking at moats as well. In a way, they manage to present both sides of a story.

On one hand, they encompass a lot of those advantages that you mentioned that a company can leverage year after year for those outsized profits, a sustainable competitive advantage. But on the flip side, at times, when there's innovation or disruption, they can highlight the path to success that an upstart player takes advantage of to grow quickly and poach market share.

An effective moat will help a company grow and remain profitable, and that will inevitably attract new entrants who might want a piece of that pie. And over time, if an upstart itself becomes a major entrenched competitor, things come full circle as it builds out its own moat, only to be challenged eventually by some other innovative, disruptive business.

We talked about a few examples, some theoretical ones and some real-world cases, too, as you were walking through that, Asit. Are there any other big instances or examples of moats that you'd like to call out before we dive into this specific example with the candy industry?

Sharma: Let's look at the consumer goods industry in general, and then we will drill down.

Shen: Sure, I think that's a great idea.

Sharma: Just grabbing market share in a particular business becomes its own economic moat. We won't talk about Mondelēz International too much in this episode, but they actually are a serial acquirer of candy brands and chocolate companies. Think Cadbury, think Oreo cookies. That itself becomes a business that has a moat around it, simply because they have the cash to pony up and build the market share, which makes it hard for other entrants to come in and disrupt their business. So that's one last model within consumer goods I wanted to point out before we jump in.

Shen: Sure. I'll even mention that last week, we looked at an industry on this segment for Industry Focus with wireless carriers, that, as an example, you have the four major wireless carriers. They all essentially share this region. They've managed to build a giant wall around it, because they all benefit from the fact that there's a very high barrier to entry for this industry in that it's a massive investment required to build out a nationwide network.

But each of the carriers, if they each have their own castles with moats around them, sticking with that visual cue, they fill them differently. In the past, for example, some carriers had early termination fees, long contract terms, high switching costs to prevent customers from changing their service to a competitor. Now, you see some smaller competitors like T-Mobile, they've reduced that friction in switching providers. They've shrunk that part of the moat. In return, T-Mobile has widened its own moat differently by using that branding built around, for example, its Un-Carrier reputation. So you can see how dynamic all that can be.

Focusing now on the debate between Musk and Buffett, the questions we're really looking at are: 1) is the moat around candy specifically as wide as Buffett thinks, given his reference to See's Candies? And 2) can Musk really disrupt the industry enough to overcome that moat, if he were to seriously pursue an opportunity like that. He seemed to be tongue-in-cheek joking earlier, but it'd be interesting to see what somebody like him could come up with, given his track record with PayPal, SpaceX, Tesla. 

Let's put the idea of moats to the test: Is the candy industry actually that tough to crack? What are your thoughts here, Asit?

Sharma: First of all, I want to just point out to listeners how shrewdly intelligent Warren Buffett is. He's the one who brought up the idea of Musk challenging Berkshire Hathaway's moat in candy. He picked the hardest business with, maybe, the widest moat. I'm going to walk through why I think it's a brilliant example. 

Although there may be, for every castle, a knight sitting on a charger pondering on the other side of the moat how to get over that moat. Although that may be true, as you point out, Vince, every castle is different, every moat is different. To me, for the sake of definition, let's just say that an established candy company of any size is going to have above what we call the middle market revenue. My round number is, if you can make $20 million annually in revenue or above, that's a good working definition for this argument. Now, candy companies, think about it, they sell one of the cheapest commodities on Earth to one of the most finicky customer groups you can imagine, and that's children -- I should say, of all ages. Bear that in mind. It typically takes years, actually decades, to establish a candy brand at scale. I talked about Mondelēz, how they have billions at hand to acquire companies. Only yesterday, they forked over $500 million to acquire Tate's Bake Shop. If you've got those billions, that's great. But if you don't, you have to establish your brand. 

Why is it so hard to get to scale in the candy industry? There's a really problematic cycle in candy, and that's the cycle of the fad. A fad can last seven years, it can last ten years, it can last 15 years. The margins in candy are so thin, they don't really justify investing in fads. Let's say Vince and I decide we want to go into business together and form a candy company. We go to Wall Street. Despite all our other fantastic credentials, and what great salesmen we are, [laughs] I think the folks at the other end of the table are going to say, "You know, we don't want to put $30 million into this project, because this brand that you've come up with sounds great, but it may only run for 12 years. And that capital investment isn't worth it for us." Few want to risk millions in capital just to break in via innovation.

Now, the end user, the child or the kid of any age, is really capricious in his or her tastes. So to break into this business, you have to copy what works. Here's the catch with that: Kids like what they like. They don't respond to close copies of products the way adults do. Adults are thinking about how much something costs, about whether the ingredients are wholesome or not. There's a whole range of factors that anyone who's an adult will consider. A kid loves a Snickers bar and doesn't want anything different. 

Maybe a little bit later in this segment, Vince, we'll talk about how old some of these candy companies are. It's just another barrier to entry. The suite of candy bars that's in a grocery aisle that you see when you check out is the same as when I was a kid, and I've got a lot of grey on me. I'm sure some of our listeners have an equal amount of grey on them. That hasn't changed, except for some innovation. 

I'll flip it back to you, Vince. I'd like to talk about the economics of the industry in just a bit, but those are the major qualitative factors I see. It's extremely difficult to cross the moat that a candy company owns.

Shen: Yeah. I'll just say, beyond what you mentioned in terms of very finicky, fickle consumers there, if you're not one of the industry leaders that has established relationships with your distributors, you have shelf space already at the store, you have to navigate so many things in terms of commodity prices, packaging, the distribution to thousands and thousands of different convenience stores, vending machines, grocery stores, to actually reach a serious scale in the space like you mentioned, beyond that middle market size of $20 million or more in revenue. That's a really, really tough challenge.

Then, moving on a little bit to some of that innovation, disruption element of it, in terms of what we're actually seeing in the candy industry, and what somebody who's a visionary and has some crazy idea for the industry, what they're grappling with. This is slightly more anecdotal evidence, but I'll just start by highlighting for listeners what the candy industry itself considers to be innovation. I found the 2017 Innovative Award winners from the Sweets & Snacks Expo and the National Confectionery Association. A few of the nominees for the chocolate category last year were: Caramel Chocolate M&M's from Mars, Reese's Crunchy Cookie Cups from The Hershey Company (NYSE:HSY), Oreo Chocolate Candy Bars from Mondelēz, which we've tried here at Fool HQ, and Kinder Joy from Ferrero U.S.A. 

The M&M's actually ended up taking that award. And I don't know about you, Asit, but caramel chocolate M&M's, difference in flavoring, otherwise it's not something that's all that different in terms of the final product to me. If those are what the industry nominated as some of the most innovative new products for that category, that tells me you don't have as much space there to disrupt with some crazy new product. It doesn't seem like that would be such an easy step. And while I do think a major consumer goods company could launch an attack on a candy company and eventually overcome part of its moat, I think it comes at a great cost, and there's no guarantee of long-term success, kind of what we mentioned in terms of the fads having a finite life. That would explain why most companies do acquire their candy businesses instead of building them up organically.

I'll pass it back to you to cover some of the examples that you found with candy companies and how far back their origins reach, then we'll start closing out the discussion with some final thoughts on the moat situation here.

Sharma: Sure. Interesting, the examples that you cited, Vince, would be familiar to anybody. We talk about staying power, the difficulty of getting into the business, and how hard, once you're an incumbent, it is to dislodge you. Mars Bars, Snickers, Three Musketeers, these are all owned by Mars International. All these brands were introduced in the 20s and 30s -- that is, the 1920s and 1930s. That company was founded in 1911. See's Candy, which is Warren Buffett's/Berkshire Hathaway's chocolate company, chocolates in a box, founded in 1921. Tootsie Roll Industries (NYSE:TR), founded in 1896. Hershey's, 1894. Haribo, which, if you love jelly beans, that's very familiar to you, 1921. And one more, Ferrero, which is the Italian chocolate giant, was formed in 1964. 

The issue that an entrant has coming into this business, and why these companies are so fierce to compete against -- one is the economics are extremely difficult. I did a Google search yesterday just for fun on Tootsie Roll. I came up with a five-pound bag of Tootsie Roll midgees candy -- and this is sold off of Amazon -- it's 760 pieces for $5.99. Now, bear in mind, this is through Amazon, meaning thereby you're getting it cheaper than you would in the grocery store. Tootsie Roll Industries makes a 16% net profit each year. But this product is selling for a unit price of $0.007. That means the selling price for each of those midgees is seven-tenths of one penny. 

And beneath all of that, supply chain mastery, manufacturing prowess, distribution expertise, which Vince mentioned, that you can imagine is a whole other realm of economics expertise. That is, there are two primary ingredients in the candy industry: sugar and cocoa, which are phenomenally hard to keep track of in your own costs. If you enter this business, you have to be a master at hedging commodities, hedging cocoa, hedging corn syrup, hedging sugar. And you have to be an expert at making sure that what you purchase in quantity gets consumed. If you read the 10-K reports, the year-end reports, of Hershey's or Tootsie Roll Industries, both of which are publicly traded, you'll find that each year, they finish with zero backlog. That means they're ultimately extremely precise at predicting how much product needs to go to distributors so that major companies like Walmart can keep the shelves supplied but no more. So again, this is a business that's so much more complex than it might appear on the surface. 

Just to recap this idea of figuring out what might sell and then being able to parlay that over decades, I mentioned the Ferrero chocolate company in Italy, the chocolate empire that's very popular in Europe. They made their money, they built their whole business, on one product, which was the invention of Nutella, which again, is a taste you develop in childhood and for many, stays with you throughout your lives. A single product. Sometimes, to me, it seems like blind luck. You come up with a great product. Those of you, again, who have a little bit of grey on you will remember the commercials from the 70s and 80s. Your chocolate's in my peanut butter, your peanut butter's in my chocolate. A serendipitous combination of ingredients leads to a hit product that's so difficult to create in real life, in terms of experimentation and innovation. If that happens to you, run out, get the capital, and then build a company that will last for decades upon decades. But again, it's not a business that, in my opinion, even if you're Elon Musk, you can just say, "I'm going to start a candy company and I'm going to challenge the giants."

Shen: Yeah. Wrapping up our discussion, then, I think there's good reason why so many people here at the Fool and other long-term, Foolish-minded investors see a lot of strength and value in companies that have built up economic moats. We also know that companies should continue to be working to widen their moats or fill it with flames instead of alligators, or whatever it is, in terms of what differentiates that as competition, the business environment evolves. And even for the candy companies, a mile-long moat might mean little if the castle, for example, itself is shrinking because consumers are moving away from sugary snacks as a result of health and diet consciousness. There's a lot of moving pieces there. 

But I think, if you're an investor, you're looking for strong companies to add to your portfolio, that's a really good part of the due diligence process, to consider, what are the challenges for that company in terms of competition? What helps them stand apart? Is that sustainable over time? Does that allow them to generate outsized profits and sustain that year after year? If they can do that, that's something you should be paying closer attention to.

Asit, any final comments from you before we roll up here?

Sharma: I just wanted to reiterate what you're saying, Vince. If you look at The Hershey Company, they bought Amplify Snack Brands last year. That gets them an entry into the salty snacks business. That's the maker of SkinnyPop Popcorn. Moats are always widening, they're always narrowing. 

The purpose of people like Elon Musk is to be the native disruptor, that knight on the charger who sits contemplating the moat. The purpose of people like Warren Buffett is to be the owner of the castle inside, figuring out how he can make that moat harder to cross. And ultimately, that dynamic produces great companies to invest in.

At the end of the day, they each have a point. But on this particular issue, we hold them to the Twitter and Warren Buffett's annual meeting interview, in which he gave the quote that you first read, I believe that Buffett ultimately is right. In the candy business, get a moat, it's yours to keep, just work on widening it. But there are other businesses, as we've seen, especially technology-oriented businesses, what Elon Musk is doing at Tesla, those moats are inherently susceptible to innovation and being attacked.

Shen: Alright. Thanks a lot, Asit, for joining us today!

Sharma: A pleasure!

Shen: People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thank you for listening and Fool on!

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Asit Sharma has no position in any of the stocks mentioned. Vincent Shen owns shares of Amazon and PayPal Holdings. The Motley Fool owns shares of and recommends Amazon, Apple, Berkshire Hathaway (B shares), PayPal Holdings, Tesla, and Twitter. The Motley Fool is short shares of The Hershey Company and has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple. The Motley Fool has a disclosure policy.