It doesn’t take long to come across the term moat when consuming investing content. For many investors the term can seem nebulous. Moats are the mythical creature of investing. We are told they exist. Some investors see signs of them everywhere. But for most investors – try as we might – identifying a moat seems just out of reach.

The term is generally attributed to Warren Buffett. If Buffett cares about moats than perhaps, we should too. At Morningstar we certainly care about moats. For each of the roughly 1600 shares we cover globally our analysts opine on the existence or lack of existence of a moat. We have a moat committee to add rigor. Former analysts even wrote a book on moats with the self-explanatory title Moats Matter.

A moat is a sustainable competitive advantage. The imaginary of moat as a body of water to protect a castle is apt as a moat protects a company from competition. To offer effective protection the moat must be sustainable. A company may benefit from a first mover advantage but without the protection of a moat those advantages will be eroded over time by competitors eager to get a piece of an attractive opportunity. A company that our analysts believe will sustain a competitive advantage for 10 years receives a narrow moat rating. A wide moat rating denotes am expected 20-year sustainable advantage.

To be a great investor is to be a student of business. We are evaluating businesses when we consider which share to buy. Once we’ve purchased a share we are an owner of a business. And any evaluation of a business starts with the environment the company operates within.

For most of the world that environment is capitalism. And capitalism is synonymous with competition. When functioning correctly competition benefits consumers. Companies invest in creating better products and services for us to buy. And they compete on price so we get better deals.

The problem is that competition isn’t great for companies. It means spending more money on research & development and marketing. It means eroding profit margins as prices on goods and services are cut. The combination of that spending and lower prices means lower profits.

We can see the impact of competition in the financial statements of companies. A company funds itself using loans from banks, by issuing debt and by selling shares. This funding has a cost and when it is invested in growing the business it earns a return. If that return is below the cost eventually the company would go bankrupt. If the return is higher than the cost of capital the company thrives over the long-term.

These outlier scenarios are rare. Over the long-term most companies find their cost of capital and the return achieved from investing that capital roughly even. This is the impact of competition eroding returns and the fact that a company is a self-perpetuating entity that will constantly keep struggling to grow.

Earning returns that match the cost of capital is not a great outcome for investors. However, the company can keep growing and keep paying management and employees as long as enough discipline is maintained to not let the return on invested capital dip below the cost of capital.

To find a great business is to find one that earns higher internal returns than competitors in the same industry. A business that keeps more of their revenue through higher margins. That is the pathway for compounding returns over decades.

How to identify a moat

There is no magic formula to identify a moat. In retrospect we can see companies that earn higher margins and higher returns on invested capital. That is the past. What matters is what happens in the future.

To find a moat involves doing something that has become increasingly rare. It involves thinking. Put down your computer or your phone – after reading this article of course – and think about a business. Start with a product or service that you, your family and / or friends regularly use. Think about what influences your purchasing decisions. Think about what will cause you to buy a competing product or service.

Would you switch to a competing product or service if there is a slightly lower price? If the answer is yes that means there likely isn’t a moat.

Is this a product or service where new innovations are constantly causing you to switch to a better offering until something better comes along? Once again, if the answer is yes, there likely isn’t a moat.

Does the product or service become more valuable to you because more people use it? If not, there likely isn’t a moat.

Think about what it takes to deliver that product and service. What influences the cost of providing that good or service. Are their efficiencies available to companies with larger scale?

Is there anything that prevents or inhibits new competitors entering the industry and providing new goods and services that you might consider buying?

Moat sources

Answering those questions will offer clues to the competitive environment facing a company. Our analysts have added some structure to this discovery process. They have identified 5 sources of competitive advantage. Companies that exhibit one or more of these sources of competitive advantage have a moat. This framework can guide your thinking.

Network effect

A network effect occurs when the value of a company’s goods or services increase for both new and existing users as more people use them. Network effect is often found in technology enabled services such as social media, payment platforms, communications platforms, and e-commerce.

In all these cases the whole point of the services is to interact or connect with other individuals or companies. The more connections available, the more value a user derives from the service.

Intangible assets

Investors often focus on tangible assets that are reflected on the balance sheet. However, just because something can’t be seen and quantified doesn’t mean it isn’t valuable. Patents, brands, regulatory licenses, and other intangible assets can prevent competitors from duplicating a company’s products or allow the company to charge higher prices.

This moat source is broad and encompasses many different competitive environments. Intangible assets can be bestowed by government bodies to encourage innovation in the case of patents which includes drugs sold by pharmaceutical companies or new technology.

Many products and services can benefit from strong brands which induce consumers to spend more on otherwise equivalent offerings and maintain market share over multiple decades.

Finally, there are cases where local and national governments grant limited or exclusive licenses to certain businesses. They may do this in exchange for a significant investment in the case of publicly useful infrastructure or to restrict availability in the case of a casino.

Cost advantage

Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or they can charge market-level prices while earning relatively high margins. In general, cost advantages stem from scale from firms that can spread their fixed costs over huge customer bases.

Switching costs

When it would be too expensive or troublesome to stop using a company’s products or services, that indicates pricing power. For some goods and services, it is easy to switch to a competing product. For commonly purchased items competing products may simply be a shelf away.

However, some goods and services require significant effort like switching a bank account or changing software that is embedded within a personal or business process. Once a company has captured significant market share it is difficult to pry customers away since the effort involved in switching providers requires overwhelmingly better features or prices.

Efficient scale

When a niche market is effectively served by one or a handful of companies, efficient scale may be present because it is not worth it for competitors to enter the market given the small number of customers.

This can be a case when a pharmaceutical company has developed an effective treatment for a relatively small number of patients afflicted with a disease or an expensive piece of infrastructure supports a targeted market like a railroad.

This episode of Investing Compass covers Moats and can be listened to on Spotify or Apple Podcasts

Real life examples of moats

A few real-life examples bring the concept of a moat to life. The Australian banking industry is notoriously concentrated with the big 4 banks capturing sizable portions of the market.

The banking industry benefits from scale as the fixed costs of branches and technology systems can be spread more efficiently across large customer bases. Their size also allows them to access funding at advantageous rates.

Banking products also have high switching costs. Customers typically utilise multiple services by banks including various accounts and credit products. Direct deposit and bill pay services intwine banking within day-to-day life.

Each of the big 4 banks has received a wide moat rating from our analysts stemming from cost advantages and switching costs. We can see the impact when we compare the financial statements of the large, dominant banks and mid-sized banks.

For instance, Judo Bank (ASX: JDO) is a relative newcomer that has focused on small and medium sized business lending. The company has grown but is at a decided disadvantageous in the competitive landscape of the banking industry.

Judo suffers from a smaller loan book and higher funding and operational costs in relation to larger competitors. Judo has a return on equity of around 5%. The major banks have low double-digit returns on equity.

Judo recently issued debt at a cost of 6.5% over the 1-month bank bill swap rate. National Australia Bank (ASX: NAB) issued similar debt a few months ago at 2.2% over the same rate. The combination of these factors means that Judo experiences a cost to income ratio of 54%. The major banks are in the mid-40% range despite a more extensive product range. The differences in these ratios will accrue to investors over the long-term.

This single example plays out over the wider universe of companies. In a 2017 study, Morningstar researchers explored the impact of moat ratings on returns on capital invested in a company and the margin captured on revenue earned.

The following chart indicates the impact on the financial measures from a sustainable competitive advantage. Demonstrable proof that moats truly matter and investors are well served by trying to identify sustainable competitive advantages.

Impact of moats

Final thoughts

It may not be readily apparent how to identify a moat but there is nothing stopping any investor from learning the signs. The more we think about the underlying business we are buying and the competitive forces it faces the better we become at investing.

Buying companies with moats is a long-term strategy. A company earning higher returns than the cost of capital and keeping more of each dollar of sales than competitors will accrue to investors over time. Over decades these incremental differences matter. That is what makes a company great.