Investments and the medieval wisdom of moats

About 4 000 years ago, in modern-day Sudan, the ancient Egyptians sought a way to protect the thriving copper-producing city of Buhen from invaders. They realised that restricting or impeding access would provide the inhabitants of the city with a defence that would be difficult to breach: a water-filled moat three metres deep was constructed.

Fast forward a couple of centuries and the business and investment sage Warren Buffet appropriated this medieval defence mechanism into investment jargon to explain the sustainable competitive advantage that some companies have.

In an interview, he said: “If you have a castle in capitalism, people are going to try to capture it. You need two things – a moat around the castle, and a knight in the castle who is trying to widen the moat.”

As in medieval times, some moats provide more insurmountable obstacles than others.

Andrew Dittberner, chief investment officer at Old Mutual Wealth Private Client Securities, believes that being able to identify and understand the source of an economic moat, and how wide and deep it is, is important in making investment decisions.

“In an era of mounting technological disruption, competition is increasing across all industries, meaning that economic moats are becoming increasingly relevant,” he says. “Identifying businesses with strong economic moats requires a firm understanding of a specific business from both a qualitative and quantitative perspective.”

Five ways to fill a moat

Where is the water coming from?

The first step, says Dittberner, is to know the source.

Literature on the topic has listed five possible sources of economic moats over the years.

1. The cost that a customer has to incur if they want to switch between two products or services

How many times have you become frustrated with your bank, but just couldn’t commit to the time, admin burden and cost of switching to another? Just thinking about the hassle deters customers to make the leap and cross over.

In South Africa, FNB rolled out a switching campaign in 2010 where it offered to lighten the administrative burden on customers who wanted to switch existing bank accounts at other institutions with some success.

Apart from the cost of lost time and actual capital, familiarity and the cost of relearning also helps to widen a moat that is replenished by switching costs.

“A good example is the QWERTY keyboard,” says Dittberner. “Research has shown that it is not the most efficient in terms of typing speed, with the DVORAK keyboard being better in this regard. However, very few people are willing to switch to the DVORAK keyboard because they are accustomed to the QWERTY version.”

2. The power of a network

Who in their right mind would even consider it a good business decision to tackle an established and powerful network such as the internet, for example?

“Network effects were originally defined around 1900 by the president of Bell Telephone Company in its annual report,” says Dittberner. “Simply put, every new user joining the telephone platform enhanced and strengthened it, resulting in additional value for the network participants as a whole.”

Modern-day examples of the strength of the network effect as the source of an economic moat can be seen in companies such as Apple, which derives its network effect value from three sources: exchange between users, staying power and complementary products.

3. Intangible assets 

Elements like goodwill, brand, relationships and intellectual property make up the third source of economic moats.

Dittberner states that these intangible assets – non-monetary assets without physical substance, yet identifiable and valuable – only have value if they can generate economic returns over the long term.

“Certain intangible assets can be sold off separately ­– intellectual property, for example – while others such as reputation, trust and brand are tied to a specific business.

“For intangible assets like reputation and brand to carry significant value, they must have the ability to both influence a customer’s decision and provide the business with pricing power,” he says.

4. The advantage of size

The next source of economic moats is the natural advantage found in size.

“Being able to produce the same product or service at a lower cost than competitors is a significant advantage,” says Dittberner.

He cites Mr Price and Shoprite as South African examples of companies that have protected their cost and scale economic moat advantages despite fierce competition.

5. Access to capital

Access to capital can also be cited as a source for the construction of a wide economic moat.

However, some commentators have argued that over the years this source has lost some of its power.

In an article published on intrinsicinvesting.com, the authors say that while access to capital in the 1960s was a massive barrier to entry for potential disruptors, the advent of venture capital and private equity, along with banking deregulation, eroded the advantage provided by it.

“Today, it does not impede a motivated entrepreneur with a quality product or service,” they say.

Durability, and width, matter

Once a company is in the enviable position of having constructed these barriers to entry for competitors, it cannot rest on its laurels. That’s when the real work begins.

“What matters is a company’s ability to maximise its moat by reinvesting to widen it,” says Dittberner.

It’s all about that knight in the castle, constantly hard at work to increase the level of protection.

A company might have achieved a quick, deep moat with an innovative product and being first to market, but competitors will be chomping at the bit to copy and paste its solutions, often at a lower price point because the initial research and development and proof of concept have been done.

Putting in place patents to protect intangible IP assets, growing the network of users, establishing familiarity to raise the cost of switching and so on – all of this means a castle ruler who has immediately deployed a team of workers to work on the moat.

Guarding against the disruptors and black swans

What if the water dries up, or the enemy starts using helicopters?

Some financial commentators have touched on this subject, stating that for all the fuss and brouhaha around how innovation is going to change the global marketplace forever, businesses still succeed if they build defensive mechanisms against innovators trying to claim their slice of the pie.

Dan McClure and Michael Kearns wrote an article that unpacks the way disruptors can reduce insurmountable moats to mere obstacles. They argue that the only way for established businesses to guard against these threats is to respond to disruption swiftly and efficiently or become disruptors themselves.

This could mean abandoning the castle completely or in part. An example is how Google’s parent company, Alphabet, always has a few ‘other bets’ on the go.

Find the moats when making investment decisions

For Dittberner, and Old Mutual Wealth Private Client Securities, identifying businesses with wide and durable economic moats is key to investment strategy.

“We believe these companies can compound intrinsic value at faster and faster rates,” he says.

Barriers to entry remain important to secure the long-term sustainability of companies. They may, however, look different in future.

Perhaps it’s time to re-moat.

Brought to you by Old Mutual Wealth.

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