Predictability of Moats

Protecting your competitive advantages

Introduction

Some companies generate extremely high profit margins and ROICs over a long period of time. This makes many wonder why and how it’s possible to achieve this (and how long it will last). In finance, there’s a theory called mean reversion, which suggests that higher than usual returns always return to the average over time as high profitability is likely to attract competition. Think of it as a honeypot. Likewise, this causes companies to compete with each other to supply at the lowest price. Ultimately, subsequently lower prices are likely to put a dent in profitability, ROIC and shareholder value compounding.

Why are some companies able to perform above average over a long period of time and defy the financial gravity? One possible explanation is that these companies possess a competitive advantage and, more importantly, somehow manage to shield this advantage from competitors. We then speak of a sustainable competitive advantage. This phenomenon is better known as the term moat, popularized by Warren Buffett. The moat protects the castle against the enemy. The deeper and wider the moat, the more impregnable the castle will be.

Moats are connected with the Lindy effect, which means that the longer something has survived, the longer we can expect it to continue surviving. This principle suggests that the more time something remains relevant, the more likely it is to remain relevant in the future. This concept highlights the dominance of older entities over newer ones.

Concepts that have endured for a significant period have outlasted numerous others, thereby enhancing their advantage and increasing their chances of future survival. Essentially, products or services with a long lifespan possess qualities that have enabled them to survive in the past, and these qualities are likely to persist in the future. Objects that perish often do so due to their vulnerability to sudden shocks or unforeseen events, such as wars, economic crises, pandemics... On the other hand, those that survive and thrive are considered Anti-fragile.

They essentially benefit from volatility to strengthen their competitive advantages. The more unexpected events a company has endured over the past years or decades, the higher the likelihood of its continued survival in the face of future uncertainties.

A “Tortoise” is an organization that does not impose dramatic changes on its workforce, but develops a collectively strong entrepreneurial spirit that’s very hard for others to replicate. It does not let distraction come into play, it’s solely focused on achieving the long-term objective instead. That doesn’t mean the “Tortoise” isn’t wary of changing macro-economic and/or technological trends, as it is constantly looking for ways to fortify its already impregnable moat through multi-decade experience and new learnings.

Here are four examples of moats that could make a quality company a truly great “Compounding Tortoise”.

1/ Network Effects

Products or services become more valuable as there are more users. This has a self-reinforcing effect because more and more users make the network more attractive and difficult to compete with, resulting in a sustainable competitive advantage. The payments processors Visa and Mastercard are good examples of this. A payment option that is widely accepted by sellers is attractive to buyers (consumers), while a payments system that is widely used by buyers is in turn attractive to the sales channel.

2/ Brands and Reputation

Brands can also come with reputational benefits. If products or services don’t deliver what is expected, this has disastrous consequences in certain sectors. Customers are then inclined to opt for an excellent reputation, which makes the price of secondary importance. Consider testing companies or firms that supply products related to safety, but also credit rating agencies and elevator manufacturers. The importance of the products or services of these companies is so great that competing against reputation becomes virtually impossible, no matter how much money a newcomer with the ambition to enter the market throws at it. The OTIS elevator was patented in the 19th century and the company has since survived multiple wars, economic shocks and various unique events. It could be viewed as one’s poster child for resilience.

3/ Scale and Capital Efficiency

Economies of scale can be observed in different organizational and business settings, whether it be at the production level, within a specific plant, or across an entire enterprise. These economies occur when average costs decrease as output increases. Companies that build out a physical network create a barrier to entry in that high capital intensity companies can also be attractive, especially where the capital requirement confers stability and deters entrants.

4/ Slow-Growing Industry with ROIC Differences between the Key Players

Lastly, slow-growing industries aren’t favored by investors but they can offer safety during uncertain times, especially as many business models can get disrupted rather quickly. They are too boring and too predictable.