Focus on moat when investing

A MOAT is the sustainable competitive advantage that enables a business to deliver excess returns on capital consistently.

The protection of these excess returns is imperative to any company’s long-term success.

For this reason, one should evaluate a company’s moat as one of the components of an investment evaluation, particularly when assessing how much one is prepared to pay for the share.

Valuable businesses generate returns well in excess of their costs of invested capital, which attract new market entrants seeking similar returns.

The emergence of competition disrupts the supply-demand dynamic, inevitably drives profits lower and eats away at excess returns.

To insulate themselves from diminishing returns, valuable businesses therefore require moats to protect themselves and their profitability, in the form of a sustainable competitive advantage. Strong moats are a rare find. In doing an analysis an investor should attempt to assess the economics of the business and the barriers to entry in its industry.

It is relatively easy to spot a good business versus a poorly run business.

Finding a strong moat, however, is more of a challenge.

The problem is that most businesses are susceptible to quite a few different threats.

Consider, for example, the way in which technological disruption has reshaped the way in which many industries function – from financial services to hospitality and tourism to taxi industries around the world.

The second challenge is that not all moats are created equally.

A competitive advantage exists either in terms of supply (the way a company produces or delivers its products or services) or demand (how well a company’s products or services suit or serve market behaviour).

Supply-based moats dry out over time, whereas demandbased moats often remain intact.

Intuitively, it is far more difficult to control the minds of customers than it is to control one’s supply chain. Demand-based moats are thus less commonly found than supply-based moats.

Businesses with strong moats are often faced with a lack of reinvestment opportunities.

As addressable markets mature, these companies may deploy capital in new ventures outside of their moats.

Those that are able to reinvest capital and grow within the confines of their moat are incredibly powerful.