I used to assume that businesses with wide moats are going to be good investments, provided you bought them at the right price.
In Buffett’s parlance, a business with a wide moat means that it has a huge competitive advantage that keeps competitors at bay, allowing the company to earn good profits on its investment.
That seems intuitive and logical, doesn’t it? But there was a caveat. An unspoken rule. Having a moat is important, but the trajectory of the moat is even more important.
It is more important to have a growing moat than a wide one
If we only cared about the size of the moat and not the direction, over at some point we would have picked:
– Blockbuster over Netflix – Yahoo over Google – Nokia over Apple
This mistake isn’t just made by investors. Management of these companies too made the same mistake. Larry Page and Sergey Brin, the founders of Google offered to sell to Yahoo for $1 million in 1998 and was turned down. Blockbuster was offered $50 million to buy Netflix but they too turned them down.
As far as they were concerned, their moat was sufficient to defend them from competition. Despite clear signs that Google and Netflix are expanding their moats rapidly.
If we invested in Blockbuster, Yahoo and Nokia because these companies had a larger moat early on, it would have been disastrous for our portfolio.
Here’s how to spot companies with a growing moat.
#1. They are investing heavily into their businesses
These investments usually comes in three forms:
(1) Research and development to create a better product. For example, software companies and pharmaceutical companies always hire developers and researchers to develop new products and enhance existing ones.
(2) Marketing to reinforce the branding of their company and gain a larger mind share amongst consumers. For example, Apple putting up a billboard in prime areas or Nike signing endorsement deals with Michael Jordan, Serena Williams, and Cristiano Ronaldo.
(3) Capital expenditures to increase capacity, enhance reliability or boost quality of product or service. The poster boy for this would be Amazon, where the company spends heavily on infrastructure for a stronger tomorrow.
Jeff Bezos has this bad-ass quote: “Friends congratulate me after a quarterly-earnings announcement and say, ‘Good job, great quarter.’ And I’ll say, ‘Thank you, but that quarter was baked three years ago.’”
#2. They are not mortgaging their moat away by pursuing short-term goals
In the past, brands such as Victoria Secret and Coach New York were regarded as high-end and exclusive. Because of their brand power, these companies were able to charge a big margin for their products.
However, they made the fatal mistake of discounting their products to boost sales in the near-term. The process of building a high-end brand is difficult and many try and fail, but it is extremely easy to discard it all. Once lost, it is nearly impossible to regain its high-end branding.
In a similar vein, companies that reduce their investment needs in order to boost profits in the short term to please Wall Street are mortgaging their moat, especially if the competition is spending heavily to take over its market share.
#3. They are benefitting all stakeholders in its ecosystem
The most resilient businesses are those that can benefit all other stakeholders while filling their pockets with profits. Costco, for example, generates high sales volume for its suppliers, delivers the lowest prices to its customers, pays its employees well above the minimum wage, and the government loves them for keeping prices low for the people who vote them in.
When suppliers, customers, employees and the government are all satisfied with a business, it is hard to chip away at its moat.