The Moat: Antiquated Concept or Investing Canon?

One billionaire says moats are lame. Another considers them essential to the long-term success of a company. 

In this segment from Industry Focus: Consumer Goods, Vincent Shen and senior Motley Fool contributor Asit Sharma use the friendly back-and-forth tussle between two giants of the business world as a launching point to explain the concept of economic moats.

A full transcript follows the video.

This video was recorded on May 8, 2018.

Vincent Shen: Last week, Tesla 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?

Asit 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, Walmart, for 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 $15-20, 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.com. 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.