By Paul Farah

In this edition of Investing chronicles, Lockstep CEO Paul Farah explores the elusive concept of a “moat” in investing, championed by Warren Buffett himself. Discover how a moat translates to a company’s long-term success, and dive deep into various moats like brand loyalty and switching costs.

“Invest in companies with an economic moat.”

Warren Buffett is credited with making moats the “holy grail” of investing. Essentially, it is about investing your money into companies with a sustainable competitive advantage over their peers, ensuring lasting success.

While this concept seems intuitive, I struggle with it. It’s not the concept that troubles me but rather its practical application. Finding these moats is just not easy!

This week, let’s discuss these moats…

What is a moat? 

To understand a moat, let’s borrow from Buffett’s analogy.

Picture a business as an economic castle under constant siege from competitors. These rivals aim to seize the castle, i.e. take market share. The moat serves as the protective barrier around this castle. It could take various forms: being a low-cost producer, holding a franchise that’s tough to replicate, facing high entry costs like establishing a power plant, or enjoying a monopoly such as a power distributor. The broader the moat, the more impenetrable the economic castle, making the business more appealing.

I probably haven’t done the description justice, so here is Buffett’s explanation.

Why is a moat important?

Businesses come and go, but some last much longer than others. Why is that?

Besides offering a service or product that people want, a key factor is having a competitive advantage over its peers. This allows the business to survive during difficult economic times when most of its peers are forced to shut down, and thrive during the good times.

Success is far from guaranteed when investing, and one sure way to lose is to invest in unsustainable businesses. The opposite also holds true: your success rate is far higher when you invest in a company that will do well during both good and bad times.

Buffett is so good at doing this, and what so many, including myself, try to replicate is finding companies with a competitive advantage that will outperform their competition over the long term.

Examples of economic moats

Despite the challenges in finding them, arming ourselves with knowledge is never a bad idea. So, let’s cover the various types of moats and look at examples of each.

Low-cost producer
A low-cost producer is a company that can manufacture or purchase goods or services at a lower cost than its competitors. This competitive advantage allows the company to offer products at lower prices, enabling it to gain market share.

Great examples are Costco and Walmart, whose sheer size enables them to procure goods at lower costs than their competitors and pass on these savings to customers. However, it’s worth noting that while this type of moat offers advantages, it’s vulnerable to disruption, as seen with Amazon’s ability to streamline operations and undercut traditional retailers.

Network effect
The network effect occurs when the value of a product or service increases as more people use it. In other words, the more users a network has, the more valuable it becomes to each user.

It’s most commonly observed in social media platforms such as Facebook or WhatsApp, where the platform becomes more indispensable as more users join. Even Spotify has a network effect whereby its recommendation algorithm becomes more accurate with each additional user on the platform rating music.

The drawback is that switching costs can be low – it is effortless to use TikTok instead of Instagram, making it easy for users to migrate to a better alternative, as exemplified by the decline of MySpace.

High barrier to entry
In my view, industries characterised by high barriers to entry often possess some of the strongest moats. These barriers may be substantial capital requirements or intellectual property protections.

For instance, the semiconductor industry, which necessitates a high degree of expertise and substantial financial investments, presents formidable hurdles for new entrants. Not just anybody can set up a chip fabrication plant or design a world-class processor.

Similarly, the telecommunications sector demands significant startup capital, creating obstacles for potential competitors. However, it also faces challenges due to rapidly evolving technologies and the customer’s purchasing power, leading to ongoing capital expenditure at diminishing returns on investment.

Switching costs
Switching costs represent another formidable competitive advantage. When it’s difficult or inconvenient for customers to switch from one provider to another because it requires significant time and resources and causes potential disruptions to operations, companies enjoy a captive customer base.

For example, Oracle customers hesitate to switch to alternatives because of the pain involved, regardless of whether better options are available. Similarly, companies like Microsoft and Apple create ecosystems that lock users into their products and services, making switching inconvenient.

Monopoly
A monopoly occurs when a single company has exclusive control over the supply of a particular product or service, effectively dominating the market and preventing meaningful competition. This control often arises from regulatory privileges, ownership of essential resources, or technological superiority. They benefit from pricing power as consumers have no alternative.

A good example is a power distributor licensed by local or national government to distribute power through the region. It makes little sense to have two distributors in the same location, and since we all need electricity, there is little we can do regarding their pricing power.

Of course, even power distributors can lose their moat with a simple change in regulation or innovation, such as home solar becoming more affordable.

Brand loyalty
Brand loyalty, Buffett’s favourite moat, is perhaps the most challenging to quantify. Strong branding creates emotional connections with consumers, fostering loyalty that transcends product features.

For instance, I read a study on Apple vs Samsung’s branding power a few years back.

According to the study, loyal Apple customers showed the same emotional connection to the Apple brand as they did with their relatives (the ones they liked anyway 😆). In contrast, Samsung generally showed a shallow emotional connection to the Samsung brand and an adverse reaction to Apple, suggesting they didn’t like Samsung but rather hated Apple.

That is a powerful brand and perhaps why Buffett bought Apple shares in 2016.

Finding a moat isn’t easy

While understanding the concept of a moat is relatively straightforward and widely touted as the ultimate investing strategy, I’ve personally struggled with it, and I believe many others do, too.

People often cite examples like Google, Amazon, or Netflix to illustrate moats due to their industry dominance. I agree they are fantastic companies with wide moats, but it’s easy to recognise them in hindsight. What value does that bring to an investor after the fact, especially when competitors are already breaching the castle walls?

The actual skill lies in discovering a moat before others do.

There’s plenty more to discover with Lockstep.

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* Paul Farah has worked in financial markets since 2006, holding positions at prestigious firms from New York to South Africa. Now, he manages his own money and provides access to his entire portfolio through his company Lockstep Investing. The views and opinions shared are his own and are for informational purposes only, it is not intended to serve as investment advice and it does not represent the view or opinion of Standard Bank. This information should be used as a starting point for generating investment ideas, and should not be relied upon as the sole basis for making investment decisions. Lockstep Investing (PTY) LTD and the Standard Bank of South Africa Limited will not be responsible for the results of any investment decisions made based on the views provided.