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Why Competitive Moats Are Here to Stay

By Motley Fool Staff - May 15, 2018 at 9:20AM

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We're siding with the Oracle of Omaha on this one.

In this segment from Industry Focus: Consumer Goods, we conclude our discussion devoted to the friendly debate between Warren Buffett and Elon Musk on the value of competitive moats.

Despite the innovation his companies are known for, even a serious effort from Musk to launch a candy business presents little threat to Buffett and See's Candies.

A full transcript follows the video.

This video was recorded on May 8, 2018.

Asit Sharma: 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, 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 'nother 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."

Vincent 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.

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