A moat is a waterway around a castle that protects it from invaders. An economic moat makes a business resistant to competition. How can you figure out which companies have these moats so you can focus your thinking on businesses that will provide outstanding returns over many years?
Companies usually begin small, often selling one product or service with time they either grow to dominate their niche, become a fringe player, or fade into obscurity. If you can determine the outstanding companies that will dominate their industry for years to come you will be at an enormous advantage.
Competition is really tough; there exists a struggle for survival in which each company engages in a Darwinian struggle for survival. Every company tries to produce a product or a service that will attract customers and their dollars.
Every business strives to come up with better products for their customers to buy. Even the best companies cannot afford to become complacent; they have to keep one step ahead of the competition who is always nipping at their heels, trying to make better and cheaper products and deliver them faster.
Let’s look at the iPhone. It’s the most popular smart phone in the world, and as anyone who owns one, or has family or friends who own one, it’s a sticky product. What I mean by that is that when that person is ready to buy a new phone in a few years, there’s a high likelihood that they’ll buy another iPhone.
That stickiness, or brand loyalty makes gives Apple a moat. It means if they can get a large number of people in their ecosystem, buying their iPhones (and other devices) then they can continue selling them devices in the future, and also the software (apps) or streaming services that they offer. If you imagine the company as being a castle, the tendency of customers to stay loyal to Apple provides the moat.
Competitors Nipping at Your Heels
Even terrific companies like Apple have to keep ahead of the competition. As successful as the iPhone has been, there is no guarantee that it will be the dominant phone five, 10 or 20 years from now. Steve Jobs set a high bar for innovation, and it is unclear if his successors will be able to continue to innovate at the high level as its founder.
As you read this companies like Google and Samsung are working hard to make a phone that outsells the iPhone. Amazon made an attempt to break into the smart phone market with the Fire Phone, and though that was not a success, one can not count Amazon out of the smart phone game.
So while a company like Apple has a moat around their business (primarily because of their iPhone franchise) there is no way to know for sure that this moat will endure. For now it’s safe, but the corporate highway is strewn with the roadkill of companies that did not keep up with the competition.
A Moat Makes a Company Resistant to Competition
A moat is an economic barrier that makes a company resistant to competition. While it can’t protect a company indefinitely, it can increase the likelihood the company will survive. In investing you want your dollars to compound over time without you having to jump from one stock to another. Finding companies with wide moats increases your chances of long-term compounding.
Another way to think of a moat is a durable competitive advantage. It is what makes your company the top dog in the field. It is in the top position. It does not have to be an enormous company, but it has to own its unique position of power within its industry, whether that is pharmaceutical, energy, insurance, healthcare, medical devices, automotive, aviation, retail, computers, or software. Every industry usually has one company that dominates.
A company possesses a moat as a result of a product it sells, the way it delivers a service, its culture or its leadership. Often it’s a mixture of all of these things that gives a company its moat. The reason it makes sense to look for moats before you invest is that a company with a moat can enjoy being in a position of power and dominate — not just this year or next year, but five years, 10 years, 20 years down the road. As an investor, you want to invest in a company with this kind of advantage that endures during good times and bad.
If you invest in a company without a moat, you may find yourself at a big disadvantage as an investor because every year brings a new surprise. You may find that your company’s earnings have fallen short because a new upstart competitor took away half of your customers. If you have no way to resist competition you can quickly find your company is irrelevant and its stock down 30% or 50% one year because some business came up with a better soda, a new style of yoga pants or a new kind of fast food. If your company lacks a wide moat you may find your company suffers huge injuries when new companies bust through the castle walls because the business you invested in had no barrier to entry and no resistance to competition. Wide moats don’t guarantee success, but if you have the option of investing in a company with one then it’s foolish to pass over it to invest in a company without a wide moat.
Great Companies Look for Ways to Widen the Moat
Great companies not only maintain their moat, but they widen it. For Apple, this means not only keeping customer loyal to the iPhone, but developing new devices, technologies, or things for customers to buy to keep them excited and engaged. The company needs to keep widening the moat by providing products and services that customers want.
Example of Widening the Moat
Amazon began as a seller of books, but expanded to sell cameras and electronic devices, home furnishings, groceries, and other products. Then they offered Prime 2-day shipping, and are now providing same-day shipping in many markets.
Amazon started Amazon Web Services (AWS) in 2006, which has quickly become the dominant player in cloud computing, then bought the Washington Post in 2013 and Whole Foods Market in 2017.
Amazon continues to expand their streaming video and music offerings to make their “Prime” offering irresistible to as many customers as possible. All of these activities increase engagement with customers. Each year millions of people around the world become “Amazon Prime” members, and these members widen the moat by becoming loyal customers who are more likely to buy items from Amazon than its competitors.
Helping You to Find Moats
My goal is to teach you how to find moats on your own. You can take a shortcut and do an online search for “companies with moats” but there are a few problems with taking this shortcut.
- The moat you read about is not really that wide or it never existed.
- The moat once existed but is now gone.
- The articles you find may be poorly written, inaccurate or biased. You can find better numbers and facts yourself.
It can’t hurt to try a Google search for companies with moats. You may uncover some useful information.
Reading annual reports, watching videos and learning as much as I can about a company are terrific ways to become an expert on a business and determine if a company has a moat or not. You are the one investing, and you want to be as confident as possible before being decisive and buying stock. That kind of deep understanding is best achieved through learning that you can only do yourself.
To help you find companies with wide moats I will share a list of companies that I understand that have wide moats. Then I will share with you a few companies where it’s “too hard” for me to know if moats exist. Finally, I will share with you two tools that I use to find moats.
All companies loosely fall into three categories: those that possess no moat, those with narrow moats, and those with wide moats. To keep things simple, I am only interested in the latter.
Here is a List of 10 Wide Moat Companies that I understand*:
Adobe
Amazon
Apple
Berkshire Hathaway
Costco
Disney
Intuitive Surgical
Microsoft
Nike
Waters
- This is not a list of all wide moat companies. It is a small group of companies that I understand well and believe possess wide moats.
- Disclosure: I own shares of Amazon, Berkshire Hathaway and Waters.
I believe all of these companies are, to some extent, resistant to competition and they also continue to widen their moats.
I’ll briefly describe Adobe and Intuitive Surgical, two wide moat businesses. I don’t own stock in either of these two companies as of this writing.
Adobe
I know this company through my experience as a photographer. Adobe (ADBE) develops Photoshop, a powerful photo-editing software program. Adobe also develops other software programs that photographers, graphic designer and illustrators use: Lightroom, Illustrator and InDesign. In addition, Adobe develops Premiere, a professional video editing program. All of these products are considered powerful tools used by professionals.
Because Adobe is usually the first choice of image-editing software used by creative professionals, Adobe essentially has a monopoly in creative software. There are many second- and third-tier software options availabe, but none of them pose a serious threat to Adobe’s dominance. One of the main reasons that Adobe’s market share and wide moat are secure is the high switching cost.
Any photographer, graphic designer, animator, illustrator or filmmaker who wants to switch to other software and solution has to re-learn a new interface. It can take several years to learn how to use new software, especially if the new software is difficult to master. Alternative software options may offer features that don’t even stack up compared to Adobes or may not be compatible with their operating system. With so many unknown variables providing high switching costs, most professionals will likely stick to software they already understand. This stickiness provides Adobe with a wide moat and walls their customers off from any competitor’s offers.
Adobe provides terrific tools to artists, photographers, designers, marketing professionals and filmmakers and they offer them as subscriptions which encourages recurring monthly streams of income.
The wide range of people who use these products, and the reality that few other products come close to competing with their software, and the ease of use of the cloud-based subscription model all combine to provide a wide moat. Any new product innovations, such as Adobe’s new foray into stock photography with Adobe Stock will only serve to widen the company’s moat.
Intuitive Surgical
I first learned about this company many years ago. I was photographing heart surgery at the time, and one of the surgeons I worked with mentioned the “daVinci” robotic-assisted surgical system developed by Intuitive Surgical (ISRG). This company has a moat because it has a large base of installed robotic machines.
As of March 31, 2018, Intuitive Surgical had 4,528 da Vinci surgical systems installed in hospitals and universities around the world. If you added together all of its competitors together it would not come close to Intuitive Surgical’s installed base of robotic operating machines.
Intuitive surgical has also spent several years training surgical staff in these hospitals and universities how to operate its machines, which range in price from $0.5 million to $2.5 million. This familiarity within the medical community is valuable because its users are unlikely to search beyond the da Vinci system for a long time to come. A competitor would have to start from scratch in developing not only the machines, but earning the trust in the healthcare industry, which is tightly regulated and resistant to change. In addition, surgical staffs who are already familiar with the da Vinci machines would have to learn how to use a totally new system. This learning curve provides a barrier to entry for any newcomer, which further widens Intuitive Surgical’s moat.
The company also has excellent operating margins. The company not only makes money selling its expensive operating machines. In reality, these high tech machines cost a lot to build, and when they’re sold they yield low profit margins. Most of Intuitive Surgical’s margins come from selling the instruments used with each procedure, and also from fixing the machines when they need service. The instrument and service categories will likely grow over time.
Because they are the only major robotic assisted surgery machines in the world, and they help doctors do procedures with low risk of complication, Intuitive Surgical has a wide moat business.
Intuitive Surgical is already used frequently in urology and gynecology surgeries, and lots of room to grow in colorectal, cardiovascular, and general soft tissue surgical procedures. This lollapalooza of surgeries that its systems can address in the future in a world that embraces technology as a way to save money and reduce surgical errors provides a long runway and resistance from competition for many years to come.
Some Moats are Hard to Identify
I like the CVS pharmacy chain. I first saw them in my hometown of Newton, Massachusetts and have watched as they expanded across the country to Seattle. I think they would probably be a good company to own, but I don’t think they have a wide moat. I know they have competition from Walgreens, Costco, and Rite Aid and I imagine it’s hard to have a wide moat in a commodity-type business of selling medications and retail pharmacy items. It’s too hard to know if a moat exists, so I just pass on making any decision on CVS. I simply don’t know enough about the business.
In the same way, I always like to fly Alaska Airlines and Jet Blue Airlines, and I’ve heard great things about the way Southwest Airlines is run, but I have no way of knowing which company could possibly have a moat. There are other large carriers like United, American, and Delta, and these companies all seem to provide similar offerings and compete on price. I don’t see that any of these companies possess a moat. So I pass on investing on airlines.
How Do You Find Moats?
What’s the best way to find out about moats? There is no shortcut. You have to learn about the company. With time and reading you will start to figure out if a company had a moat or if it is just one of many companies fighting for scraps in an extremely competitive arena.
One thing I should mention is that the resources that I’ll show you to help you find moats contain financial information; dollar amounts and terminology like cash flow, revenue and income. These are basic accounting terms, and even if you haven’t taken an accounting course you can find their definitions through a quick search.
It might seem daunting at first, but don’t expect to understand everything right away. Learn a little at a time, and over the course of a few weeks, months and years your knowledge will compound.
The two resources I think will provide you with the most useful numbers to use in finding moats are Value Line and Morningstar Premium. I have access to databases of both services through my local library in Seattle. You may want to check if your own library provides similar access. If they don’t you can subscribe to both services on a monthly or annual basis.
Value Line provides in-depth analysis of individual companies, and in my opinion they provide the most useful set of numbers for stocks of companies in America. You can use their guides as a quick “thumbnail” of any company you’re interested in to quickly measure one business against another. Their guides give you the best way to quickly figure out which companies are worth diving in and examining deeper, and which are best to just say “no” to and move on. You’ll find Warren Buffett and Charlie Munger’s opinions on Value Line below.
Morningstar’s premium service provides analyst commentary and financial information, and in addition they give moat ratings: none, narrow, wide. I find these to be a helpful way to get a quick idea of the absence or presence of moats. Morningstar does not provide the moat ratings for all companies, and there is no guarantee that these moat ratings are accurate. I consider them a good point of departure, and along with other data will help you form a clear enough picture of the company to decide if it makes sense as an investment.
Do you Need Mathematical Knowledge?
You may wonder how much mathematical knowledge you need to understand investing in general and moats in particular. To shed some light on this, I’d like to share some thoughts from Warren Buffett. I came across this somewhat obscure video from the 1995 Berkshire Hathaway Annual Meeting.
Buffett explains what you don’t need — advanced math — and what you do need, which is the ability to understand mathematical relationships: something that tells you when things make sense or don’t. When asked if mathematical knowledge is necessary to invest, Buffett said:
“I don’t think any great amount of mathematical knowledge — advanced math is of no use in the investment process — an understanding of mathematical relationships, sort of an ability to quantify, a numeracy as they call it — I think that’s generally helpful in investments because it’s something that tells you when things make sense or don’t make sense or sort of how an item in one area relates to something someplace else, but that that doesn’t really require any great mathematical ability. It really requires sort of a mathematical awareness and a numeracy and I think it is a help to be able to see that.”
Finding Moats is All About Prioritizing and Selecting
Buffett explains that whenever you consider a company, you’re not looking at it in a vacuum; you’re comparing it against many other businesses. In this way you can see which are the “outstanding” options and which ones you can just pass over.
“I mean, I think Charlie [Munger] and I probably when we read about one business we’re always thinking of it against the screen of dozens of businesses it’s just sort of automatic and, but that’s just like, you know a scout in baseball thinking about one baseball player against an alternative you mean you only have a given number on the squad and they’re thinking you know one guy may be a little faster, one guy can hit a little bit better — all of that sort of thing and it’s always in your mind you were you are you’re prioritizing and selecting in some manner.”
Reading Helps you Find Moats
Reading is the only way you can decide if a company has a moat. You can also use your own judgement based on your experience as a customer, or on videos you have watched or the experience of friends or family members.
My own feeling about the best way to find moats is to just read everything in sight. Read many annual reports, read articles, watch video interviews on YouTube and anything you can about a company. You’ll soon see if a company has a dominant position in their industry and falls into the wide moat category or not.
Value Line to Measure One Business Against Another
Charlie Munger believes that Value Line is the best quick guide to financial numbers that you can find.
“I think the set of numbers the one set of numbers in America that are the best quick guide measuring one business against another are the Value Line numbers — that stuff on the log scale paper going back 15 years that is the best one-shot description of a lot of big businesses that exists in America. I can’t imagine anybody being in the investment business involving common stocks without that thing on the shelf.”
Comparing Industries and Businesses in Your Head
Buffett said that you need to keep framework in your head of different industries and businesses. Once you know how the numbers look in different industries and with different businesses, then you will have a backdrop to use to measure new opportunities.
He explains the need for a framework using a baseball analogy.
“I mean, you know if you’d never watched a baseball game and never seen a statistic on it you wouldn’t know whether a .300 hitter was a good hitter or not. You have to have some kind of a mosaic there that you’re thinking is implanted against, in effect, and the Value Line figures, you know, they cycle it every 13 weeks, and if you ripple through that you’ll have a pretty good idea of what’s happened over time in American business.”
Charlie Munger added, “By the way I pay no attention to their timeliness ratings or stock ratings,” to which Buffett agreed, “None of that means anything — it’s too bad they have to put that there — but it’s the statistical material, not the ratings [that matter].”
Moats are a powerful investing filter because it helps you rule out many companies. You can just discard all kinds of businesses that are impermanent or fragile and focus in on those durable companies that will probably dominate for years to come. If you are decisive on an outstanding wide moat company you don’t have to make many decisions. You can just sit back and enjoy the ride.
Whenever possible combine different mental models when you invest. For example, if you find a company with a wide moat selling at a sensible price, you will likely improve the result of using one mental model alone. Your decisions will be more effective when you use a mosaic of useful models together.
