Geoff Gannon November 30, 2012

Unrepeatable Moats

A blog I read, csinvesting, has a post about Niche vs. Moat. In my experience, most investors underestimate the frequency of moats and overestimate their size. They assume large companies have moats and small companies don’t.

Most competitive advantages are cost advantages. And most of those don’t last. But they keep excess profits in and competition out for a time.

Cost advantages are inflexible. And so any change in technology, society, industry structure, etc. can destroy them. What’s worse is that the cost advantage often reverses from something that favored incumbents to something that favors entrants. You end up with unions, agents, etc. New entrants do not.

Greenwald stresses the local nature of moats. Local competitive advantages are common. If you look at very high return businesses in areas you wouldn’t expect – banks, grocery stores, etc. – they are due to superior performance at the most local level. Each store and branch is outperforming. And the market share situation in each town deters competition.

Most investors don’t consider that a moat. Because it can’t be repeated. In the next town over, it’s useless.

That’s true. But it’s also different from a big company making a hit tech product. They have nothing that can be defended. The profits are due to scale. But the scale – market share – is threatened by something others can and will try to take away.

There’s a book – in fact a whole series – on repeatability.

You shouldn’t read Greenwald’s book without reading Zook’s books. I recently read another book on moats – The Little Book That Builds Wealth – and it makes the same mistake Greenwald’s book makes.

They both downplay management. On the one hand, they are right to do this. Management is not a moat. On the other, they are wrong. Management often grows a culture around a moat.

In fact, today’s management is often less important than the management that formed the company’s identity. Day to day decision making is not important. Keeping the company focused on the moat is. The key manager doesn’t have to be alive to do that. People just have to remember him.

The most durable advantage a company can have is a cultural identity locked up in a moat. Most companies should not try to be cost leaders in everything they do. But if that is your moat – you shouldn’t spend a minute thinking about anything else.

The reason Southwest (LUV) and Wal-Mart (WMT) built the moats they built is due to the cultures their management created. They had one good idea. And they took it seriously.

Most companies are more scatter brained. If they see a good idea, they act on it. But ideas do not exist in isolation. A chain of good ideas often leads to one really bad habit.

Most companies that have moats are not conscious of those moats. Warren Buffett invested in the Washington Post (WPO). The people at the Washington Post knew how to write good articles. They did not know how to build a moat. They did not realize that – if there had been 5 daily papers in D.C. – and their articles were twice as good as anybody else’s they’d be a money losing operation.

The quality of the paper had little to do with its success. And in some areas, it probably hurt. A lot of high quality papers end up downplaying local coverage, sports, etc. to make room for their great journalism. This may be good for the world. It is, however, against their subscriber’s wishes. And it does nothing to widen the paper’s moat.

Newspapers are naturally a very bad business. They are only a good business – and then they are a truly great business – under a very special set of circumstances. From about the end of World War 2 until the start of the internet, that set of circumstances existed in a lot of U.S. cities.

But – even then – the most profitable papers were never the highest quality papers. They were the most dominant papers. Look at the record of The New York Times (NYT). And then look at the papers in Buffalo and Milwaukee. Which had the widest moat?

Those papers had moats. But they were unrepeatable moats. The interesting thing about The New York Times – and all brands – is that they are repeatable. If you do it right, you can slap that brand on other things and deliver it in new ways to new customers in new cities.

But most growth is growth away from the moat. It is much easier for a company to grow its business than it is to grow the moat. The result is unprotected growth. And it often leads to an island of high returns surrounded by vast fields of low returns.

People ask if a company like Omnicom (OMC) has a moat. Of course it does. Every advertising agency has a moat around every client. Moats really are that small.

We tend to think of moats as a zero sum game. They don’t really work that way. Industries with moats around each customer, each town, each title, etc. are better for all the survivors. They discourage high cost warfare over low return territory.

We tend to call those niches. But most moats are niches. The rare thing about something like Coca-Cola (KO) is not how great the moat is. It’s how much territory the moat protects.

Look at Coca-Cola and Games Workshop. Their pricing power is similar. But one is 500 times bigger than the other.