Mental Model Lollapalooza: Competitive Advantages
How Warren Buffett & Charlie Munger got rich hunting for moats
Mental Model Lollapalooza
Charlie Munger is the business partner of Warren Buffett and one of the most successful investors of all-time. He is a huge believer in gathering a ‘latticework’ of elementary mental models from a variety of disciplines in order to improve your decision-making in business, academic research, and virtually all aspects of life. Through this series, the Mental Model Lollapalooza, we will explore around 100 mental models (the number Munger himself uses) to arm us with a multi-disciplinary toolkit to understand the world around us.
Click here for a link to the main mental model lollapalooza article.
Moats
“In business, I look for economic castles protected by unbreachable moats.” — Warren Buffett
Competitive advantages, barriers to entry, and moats are all just different ways of saying the same thing: for some reason, your competitors can’t do what you’re currently doing.
Finding companies with this unique characteristic forms the core of Berkshire Hathaway’s investment philosophy. Why? If a company has a durable moat, it should be able to continue to make above average returns for as long as its moat remains.
Check out this video to hear Buffett discuss this in his own words at the 1995 Berkshire Hathaway annual shareholders’ meeting.
In a world with ever-increasing technological change and globalisation, it is more important than ever that not only have you identified a company with a moat but that the moat is durable and will continue into the future.
As Buffett mentions in the video above, the key to identifying this comes down to understanding the nature of the moat and being able to make reasonable assessments as to how potential developments will impact it. Additionally, understanding the company’s strategy with regards to protecting or growing their moat is key to understanding its durability.
Identifying potential developments and contemplating their impact on a company’s moat means you must have a solid understanding of the company and industry. This is what Buffett calls his circle of competence, something we’ll cover after exploring how we find moats and the general forms they take.
Types of Moats
There are many ways to slice and dice the different economic moats that may benefit a company, but Bruce Greenwald’s classification is a great one to emulate. That’s what we’ll look at below.
Supply advantages
This is when a business can supply something that others either aren’t able to or can’t compete with the incumbent on costs and take the form of:
Patents
Patents grant a business exclusive rights to use a certain manufacturing process or product. These generally protect products or processes for 20 years, but this doesn’t stop competitors trying to make something as close as possible to the process or product under patent without infringing on it.
This is the main supply advantage of pharmaceutical companies. I’m not a pharmacist and I consider that industry well outside my circle of competence, so I’ve had little call to consider companies patents as part of a company’s moat.
Lower costs
This can be an outcome of a patent if said patent protects a process involved in manufacturing that is critical to the business. It can also be due to access to cheap labour or capital. Finally, in industries where tacit knowledge and experience matter greatly, incumbents will always be further along the learning curve than new entrants, though this does have a diminishing effect.
An interesting example of access to cheap capital comes in the form of the world’s largest investment banks. It is generally agreed that they are too big to fail (i.e. the government will bail them out rather than let them go bankrupt) and as such prior to the financial crisis were able to access capital cheaper than smaller banks or other industries, as investors knew their capital was likely safer with those banks.
It is rare in practice to find these supply advantages and for them to be durable enough to base a valuation on.
Proprietary technology
Similar to patents, if you own a piece of technology that your competitors haven’t yet figured out how to replicate, you could find yourself with a competitive advantage. This is likely to manifest itself in tech companies, but with the rate of technological development, it’s unlikely you’d be able to have confidence in the long-term durability of this moat unless you are also intimately familiar with the industry-leading technology of the industry.
Demand advantages
These are when you have access to market share that competitors either can’t take away from you either legally or because it would cost too much.
Government contracts
Having a licence from a government to exclusively operate a business can constitute a competitive advantage. For example, utility companies and rail franchises. It is important to know the length and exclusivity of the licence as well as potential upcoming government policies that could increase competition when basing a valuation off these licences.
Customer captivity
Some people argue that great brand recognition is itself a source of competitive advantage. Greenwald applies more rigorous criteria to his definition of moats and requires some level of customer captivity to be present for a brand to warrant being considered. His rationale is that well-financed competitors could simply match your company on marketing spend, eat into your market share and establish their own brand if there is no intrinsic reason why customers should stick with your business.
These reasons fall into three categories: habit, switching costs, and search costs.
- Habit is where users buy your product in auto-pilot, such as when choosing Coke over a store’s own-brand cola drink. This customer captivity is most usually present in high-frequency purchases/engagement with the company. (e.g. cigarettes, soft drinks, magazines), but it could be argued that Apple fanatics buying the new iPhone at the time of release without even considering any of the android phones available is a form of habit as well.
- Switching costs are incurred when the action of switching to a different supplier would result in significant costs. Companies switching business-wide software and requiring the re-training of all employees is a common example- even if a competitor’s product is superior, the cost of switching will often be too high to incur.
- Search costs are present when it is time-consuming or expensive to search for alternatives to your current supplier. Bundling products together or providing benefits that are hard to quantify in monetary terms can make it a lot more difficult to compare products between competitors.
Economies of scale
Economies of scale are considered to be the most durable moats.
Government contracts get re-tendered, patents expire or get worked around, and new customers enter the market reducing the need for a superior product to convince laggards to switch over to them negating some of the advantages of switching costs. It can often be hard for a business to come up with a strategy to maintain or increase these competitive advantages over time.
Economies of scale, however, are durable and can easily increase over time through no mechanism other than the fact that they already exist. How?
Economies of scale mean that by dominating a geographic region or product space, you are able to do one of the following:
- Spread fixed costs over greater order volume (essentially allowing you to out-invest your competitors in areas like marketing or R&D).
- Provide a superior product to your users through network effects.
Coca-Cola has the most visible economies of scale moat. Let’s say that Coca-Cola and every other soft drink manufacturer all spend say 40% of their profits on marketing. On an absolute basis, Coke would have a much greater marketing presence as their 40% comes from a much larger profit. Similarly, they can invest more (on an absolute basis) into market research, new product development and expanding into new markets than any competitor simply by already being bigger.
Additionally, on an operational basis, Coke should be able to run its distribution and bottling operations at a more efficient level due to the volume of products they’re shipping. This adds more profit to their business, meaning that if Coke and competitors are all spending 40% of their profit on marketing, Coke has not only the advantage of having more profit than competitors due to higher revenues, they also have a higher profit margin due to their increased sales.
Signs of a Moat
In Competition Demystified: A Radically Simplified Approach to Business Strategy (Amazon affiliate link), Bruce Greenwald highlights some early-warning signs that a moat might be present. These can help you to quickly discard or invest more time into companies you are researching.
- Few competitors: If there are few companies competing directly with the one you are researching, barriers to entry could explain this. Not all companies with few direct competitors have competitive advantages, but all companies with competitive advantages have few direct competitors.
- Stable market share: If the company has been able to maintain, or increase, market share in the face of competition, this could be a further hint that a moat exists.
- High return on invested capital: If the company is able to enjoy supernormal profits, its competitors haven’t driven them down; this could be because they are unable to.
Not having these signs doesn’t necessarily mean a moat isn’t present in the company you are researching. Take for example the semiconductor industry; according to a recent Economist article ‘the number of manufacturers at the industry’s cutting-edge has fallen from over 25 in 2000 to three’. This clearly does not indicate stable market share. It does however suggest that the remaining companies had some economies of scale in their operation that allowed them to keep their research & development, as well as their manufacturing capabilities, ahead of competitors.
In addition, due to some recent development, a company may have just created a moat that hasn’t yet resulted in high returns or stable market share, but that may prove to be an incredibly profitable investment if spotted early on.
Circle of Competence
A foot wide and a mile deep
From the 1996 Berkshire Hathaway annual report:
What an investor needs is the ability to correctly evaluate selected businesses. Note that word “selected”: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.
If you don’t understand a company or the industry it operates in, you aren’t going to be able to accurately assess its competitive advantages. Peter Lynch covers different types of stocks and the idea of buying what you know in One Up on Wall Street (Amazon affiliate link), but it is Warren Buffett and Charlie Munger who have tirelessly sought to convey this message to their shareholders and other investors over the years.
How do you know if something is in your circle of competence?
To ask the question [of whether you are past the boundary] is to answer it. — Charlie Munger
It is in human nature to be initially over-confident in our abilities when learning a new field; it is a well-known problem called the Dunning-Kruger effect.
When evaluating a company to understand its circle of competence, it’s important that you make a rational assessment of your own knowledge of the industry and the specific company, as well as things like your ability to understand and interpret financial statements, in order to counteract your own biases.
Mental Model Lollapalooza Catalogue
Thanks for reading this far! If you enjoyed this article, be sure to check out the catalogue of other mental model articles (click here for the link) to further broaden your multidisciplinary mindset.
