The Direction Of The Moat

Everyone talks about “moats” but almost no one talks about how moats change. Moats get a little bit wider or narrower every day. A widening moat is even more valuable than a wide moat. A moat’s direction is more important than its width.

Why? A widening moat implies longevity. It’s one thing to have high returns on equity. Plenty of businesses do. Long-term investors care about how much capital a business can invest at a high rate and for how long.

Nick Sleep’s insight wasn’t that Amazon had a wide moat. Amazon was losing money when he first invested. It only had a kernel of a moat. Sleep’s insight was that the company’s “scale economies shared” business model was self-reinforcing and its moat would perpetually widen.

Charlie Munger likes Costco for the same reason. Costco’s business model and culture produce positive feedback loops and lead to insurmountable scale advantages that perpetually widen its moat.

At Berkshire’s 2000 annual meeting Buffett commented:

So we think of the — we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business.

And to our managers, we say we want the moat widened every year. You know, that does not necessarily mean that the profit is more this year than last year, because it won’t be sometimes. But if the moat is widened every year, the business will do very well.

When we don’t have a — when we see a moat that’s tenuous in any way — getting back to your question — it’s just too risky. We don’t know how to evaluate that, and therefore we leave it alone.

Buffett doesn’t invest in businesses with “tenuous” or narrowing moats anymore because they’re too risky and too hard to evaluate. He learned his lesson from Berkshire’s original textile mills.

Berkshire’s 2005 letter to shareholders explains that widening the moat is Berkshire’s number one priority:

When our long-term competitive position improves . . . we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long- term conflict, widening the moat must take precedence.

At the 2022 Graham & Dodd Annual Breakfast Todd Combs recalled the first time he met Charlie Munger. Munger asked what percentage of S&P 500 businesses would be a “better business” in five years. Combs said less than 5%. Munger thought less than 2%.

By their math 10-25 companies in the S&P 500 are getting better and 475-490 are getting worse. Technology has increased the rate of “creative destruction” which has made widening moats an endangered species.

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Buffett asks Combs almost daily “if the moat is wider or narrower on any of their businesses.” Combs admitted it is a tough question but so important that they consider it often.

Companies with wide but narrowing moats can be value traps. Kodak once looked as dominant at Coca-Cola, Buffett told students at University of Florida.

They’ve [Kodak] lost some of that. They haven’t lost it all…but they let that moat narrow. They let Fuji come and start narrowing the moat in various ways. They let them get into the Olympics and take away that special aspect that only Kodak was fit to photograph the Olympics. So Fuji gets there and immediately in people’s minds Fuji becomes more on parity with Kodak. You haven’t seen that with Coke. Coke’s moat is wider now than it was 30 years ago. You can’t see the moat day by day, but every time…the infrastructure gets built in some country that isn’t yet profitable for Coke but will be 20 years from now, the moat is widening a little bit.

Changes in a moat are hard to quantify in the short term because widening a moat can depress margins, earnings, and returns on equity.

When Nick Sleep was buying Costco, analysts were lamenting its structurally low margins. What Sleep understood to be a key feature of Costco’s moat looked like a bug to everyone else.

Costco widens its moat by foregoing higher margins in the short term to maximize profit dollars in the long term. It’s deferred gratification. A company neglecting its moat, like Kodak, can report higher earnings in the short term by scaling back advertising and cutting R&D. Instant gratification. In the long-term it will pay the price, as Kodak did.

Combs said 98% of what he and Buffett discuss is qualitative. That’s not to say Combs and Buffett aren’t quantitative. They keep their quantitative analysis simple and work through it quickly.

Combs explains: “If something is 30x earnings you can calculate what it will have to do to get to run rate earnings.” Since they don’t build giant complicated DCF models, they can afford to spend 98% of their time thinking about the qualitative.

This is what Munger means when he says, “People calculate too much and think too little.”

Understanding the direction of a moat requires a deep understanding of the business. Investors that stick with stocks for decades focus on KPIs that indicate whether the moat is widening or narrowing. They’re not focused on traditional metrics like EPS or P/E ratios, and certainly not adjusted EBITDA.

For example, in Berkshire’s 1986 letter to shareholders Buffett wrote:

“The difference between GEICO’s costs and those of its competitors is a kind of moat that protects a valuable and much-sought-after business castle. No one understands this moat-around-the-castle concept better than Bill Snyder, Chairman of GEICO. He continually widens the moat by driving down costs still more, thereby defending and strengthening the economic franchise.”

Buffett compares GEICO’s expense ratio to its competitors to gauge whether its moat is widening or narrowing. He’s not focused on GEICO’s quarterly earnings or premiums written. Those will ebb and flow, even if its moat is widening over time. If he’s right about GEICO’s expense advantage, GEICO’s EPS and premiums written will eventually take care of themselves.

Focusing on a widening moat can allow investors to stick with a stock through a drawdown or period of lower earnings. For example, Dollar General’s margins, earnings, and stock are all well off their highs. But the company continues invest in initiatives that widen its moat: new stores, more cooler doors, an in-house distribution fleet, etc.

A widening moat implies a long-lived moat. Time is their friend. Investors in widening-moat stocks tend to stick with their pick for decades. Sleep did with Amazon, Munger with Costco, and Buffett with GEICO. That’s why Munger said to find Costco’s, not exits:

“I’m no good at exits. I don’t like even looking for exits. I’m looking for holds. Think of the pleasure I’ve got from watching Costco march ahead. Such an utter meritocracy and it does so well, why would I trade that experience for a series of transactions? I’d be less rich not more after taxes. The second place is a much less satisfactory life than rooting for people I like and admire. So I say find Costco’s, not good exits.”

Some Examples

So, what are some stocks with widening moats? They’re surprisingly tricky to find. It’s easy to confuse a moat that is wide but stable or narrowing with a moat that is widening but might not yet be wide.

Here are a couple of brief ideas about companies with widening moats. If you have any ideas feel free to share them in the comments section below.

Network effects are self-reinforcing which should make businesses that benefit from them a fruitful hunting ground. But just because a business has network effects doesn’t mean it has a widening moat. eBay has network effects, but its moat has undoubtedly narrowed. Visa has a very wide moat, but is it widening? I don’t know.

Old Dominion operates a hard-to-replicate network of LTL freight terminals which allow it to offer better service (on-time, undamaged, etc) than its rivals. Its higher returns on equity and higher profits allow it to invest more than its rivals, widening its moat.

Copart operates a digital network which benefits from self-reinforcing network effects. The more cars Copart auctions, the more buyers it attracts. More buyers produce higher prices, which attracts more sellers. Copart also owns junk yards near major metropolitan areas which are hard to replicate because of zoning and NIMBY-ism. Copart owns its real estate outright, unlike its primary rival, which leases. Higher interest rates and inflation enhance the advantage of Copart’s owned real estate.

Hilton and Marriott operate loyalty programs which have network effects. A large selection of hotels incentivizes customers to use the loyalty program, which makes hotel owners want to become franchisees to access their demand.

Economies of scale can be self-reinforcing too. AutoZone and O’Reilly have leading positions in a highly fragmented industry which gives them significant relative scale advantages over their mom-and-pop competitors. Alimentation Couche-Tard is in the same position in the convenience store industry. These businesses earn higher returns and profits than their peers which allows them to reinvest to widen their advantage.

I like looking for companies with a leading position in a fragmented but consolidating industry. Watsco’s relative scale advantage in HVAC distribution allows them to stock more inventory and invest in better technology. Fergusson is similar, but in plumbing. Cintas has leading scale and route density, which allows them to serve incremental customers at a lower cost then rivals. The same goes for Rollins and Terminix.

Standards-based moats, like Moody’s and FICO, widen as their standards gain adoption and are written into regulations. These spread and reinforce themselves like network effects.

Prestige and nostalgia take decades to incubate and cannot be quickly replicated. Luxury brands like Hermes and Ferrari offer prestige, which partially derives from their long brand histories. American Express isn’t a luxury brand in the same vein as Hermes, but Millennials and Gen Z seem to like it.

Nostalgia applies to lower priced brands like Coca-Cola and Hershey’s. We grew up with these brands, and have fond memories of them and positive associations with them. These feelings grow with time and are hard to replicate quickly.

The largest alternative asset managers, like Brookfield, Blackstone, and KKR, tend to get the biggest inflows. Their brands have prestige and they have sufficient scale to accept massive checks. The big keep getting bigger.

GEICO and Progressive have a cost advantage over their rivals. Progressive seems to have a data advantage over GEICO, but that moat is narrowing as GEICO catches up in telematics. While I consider both to have a wide moat, I am unsure if they’re widening or merely stable.

Putting It All Together

The direction of the moat is more important than the width of the moat. Widening moats imply longevity and high incremental returns on capital.

It’s more important to track the width of a moat than quarterly EPS. If a company’s moat is widening, earnings will follow. Tracking a moat can insulate investors from the inevitable ups and downs of a business’s earnings and stock price. A widening moat should give investors conviction, staying power, and what Tom Russo calls “a capacity to suffer.”

Stocks with widening moats benefit from time. Investors fortunate enough to own one should not be quick to sell it. As Munger says, look for Costco’s, not exits.

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