A question I ask myself when looking at a company is whether its moat is filled with milk or wine. Before you immediately stop reading this and vow never to read any of my articles again, please let me explain.
As milk ages, it tends to spoil and becomes less valuable. After a while, it's completely worthless. On the other hand, a fine wine becomes more valuable with age. It becomes more scarce and its quality improves.
So how do we tell whether a moat is filled with wine or milk? Let's take a look at some of the competitive developments that could erode a moat.
The Red Queen Syndrome
In Alice's Adventures in Wonderland, Alice finds that she has to run faster and faster just to stay in place. Many technology companies face the same problem, which is probably why many value investors refrain from investing in technology companies.
Consider Polaroid. A long time ago, Polaroid had a camera that could instantly develop photos. However, camera technology is always changing, with quicker, smaller, superior cameras being developed every year. Eventually, Polaroid, once a blue chip and member of the heralded "Nifty Fifty," went bankrupt.
Other tech giants that I think fall into this category are Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG). I'm not, by any means, predicting their imminent demise. All I'm saying is that these companies need to keep releasing newer and better products and services -- such as better music players and search engines, in order to stay king of their hills. Yes, it is true that to some extent Apple has locked in its customer with the iTunes proprietary system, and that force of habit will keep customers going back to Google even if someone develops a better search. However, with these companies, there's no guarantee that they'll be on top in 15 years.
The reset button
According to some scientific theories, a long time ago a big meteor crashed into the earth, resulting in a huge temperature change, which paved the way for the rise of mammals. According to this theory, mammals were warm-blooded and could burrow underground and survive the climate change. Dinosaurs were unable to adapt and went extinct. When the environment became less hostile, the mammals came out of their holes and proceeded to dominate the terrestrial earth's population.
According to this theory, there was basically a gigantic reset button pushed, where a structural shift in the environment caused some winners to become annihilated and new winners to emerge. Investors should avoid like the plague companies where a reset button might wipe out their business. For example, Blockbuster's (NYSE:BBI) business model has been heavily pressured by attackers on all fronts. It's got Wal-Mart (NYSE:WMT) selling DVDs as loss leaders to get more customers through the door. It's got Netflix (NASDAQ:NFLX) trying to directly undercut its distributional strengths in retail. It's got its own suppliers competing with it through the Internet-based Movielink offering, and it's also got video on demand knocking on the door.
In other words, Blockbuster, which once dominated the movie-rental business and is now trying to claw its way back from the grave, is struggling because the reset button was hit and the rules of the game changed.
So how do we figure out whether a company is prone to either problem?
I think it's important to simply ask the right questions. Every company is a conduit between its customers and suppliers. Figuring out the "rules" that govern the relationships between a company and its customers and suppliers will help investors figure out how vulnerable a company's moat is.
Is the company dependent on being bigger and badder?
Did this company come to prominence by outrunning its opponent? If so, it may be vulnerable to the Red Queen syndrome. Wait a minute, aren't all companies vulnerable to this? Well, not quite. Many consumers, if blindfolded, wouldn't be able to tell the difference between a Coca-Cola (NYSE:KO) product and the generic competition. In fact, companies like Brown Forman and Fortune Brands trumpet that their whiskey hasn't changed in centuries. Those companies aren't vulnerable to the Red Queen problem.
It's also important to note a company's ability to withstand competitive one-upmanship. Microsoft (NASDAQ:MSFT) operates in a very cutthroat environment. However, its operating system essentially allows it to have all-time home court advantage with regards to most applications. As a result, even when competitors released superior spreadsheets, Internet browsers, and word processors, Microsoft was able to eventually win the game.
Are the rules of the game prone to change? If so, how quickly will this happen?
There are many factors that determine how fast or slow the rules of the game can change (or reset). For example, the newspaper industry's primary customer tends to be much older than Blockbuster's target demographic. As a rule of thumb, the older we get, the more set we are in our ways. This helps explain why newspapers have fared much better than Blockbuster in adapting to a common threat -- the Internet. Newspaper customers are dwindling, but at a relatively slower pace, thus buying critical time needed to transition to the new rules.
This is just a simple framework for understanding a company's moat, and trying to predict the durability of the moat. At the end of the day, you should be able to understand the business, and it's interactions with its customers and suppliers. This will allow you to ask the right questions to understand how stable the company's competitive advantage is, which will help determine if your investment in that company has a margin of safety.
Related Foolishness:
Coca-Cola, Microsoft, and Wal-Mart are Motley Fool Inside Value recommendations. Netflix is a Stock Advisor recommendation. Try any of our investing services free for 30 days.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.
