Moats are Overrated

A study conducted by a Swedish psychologist found that 93% of drivers in the US believe their driving skills to be above average. This is, of course, ridiculous. There are some psychological factors at play here, but it's quite clear that we can't all be above average. If that were the case, the average itself would move up, but the vast majority of people would still be, well, average.

Something similar happens to investors.

By that, I don't mean that most investors overestimate their abilities, although that may also be the case. I mean that they overestimate the quality of their investments, which can lead to overpaying.

Many investors claim they only invest in companies with "wide moats" and "defensible positions." If this were true, the bar is so high they would make few, if any, investments.

Before we go any further, let's get our definitions straight.

As Buffett and Munger use the term, an economic moat is more than your run-of-the-mill competitive advantage. It's a competitive advantage on steroids; it's one that allows a company to earn above-average returns on capital.

On the other hand, a plain-vanilla competitive advantage is anything that a company does better than the competition; it's why some customers choose that company over others but does not provide enough of an edge to earn returns above the industry average.

Real moats are rare. There can't be too many companies earning above-average returns for long periods.

It's not that moats are overrated. It's that investors see moats where there aren't any.

Investors tend to confuse a competitive advantage for a moat. And the companies that do, in fact, have a real moat, usually can't hold on to it long. Moats tend to be finite and fixed. And fixed defenses are eventually overcome.

Lessons from Monsieur Maginot

After World War I, France anticipated another confrontation with Germany and built a series of fixed fortifications along its border. What began with modest forts soon grew onto a sophisticated network of 142 heavily-fortified bunkers, 352 casemates and 5,000 blockhouses, thousands of artillery and machine-gun positions and a complex mesh of tunnels. The line itself consisted of multiple defensive layers up to 16 miles deep at its broadest section. It was designed to have overlapping fields of fire among its various positions. Troops could move from one location to another through a network of tunnels without being exposed to enemy fire. The entire line was supported by mobile rails guns that could move to bolster a section in need. Overseeing the whole line was a chain of 78 command and control decks that could coordinate the troops and guns throughout the network. Everything was linked with a self-contained communications network. It could hold half a million soldiers in decent living conditions, with ventilation systems, running hot and cold water and living installations.

Known after its champion, André Maginot, a member of the French Chamber of Deputies and later minister of war, the Maginot Line was widely considered a stroke of military and engineering genius. And the French loved it. They felt safe and secure behind these defenses, confident that Germany would never attempt another assault on France similar to WWI.

And they were right.

On May 10, 1940, Nazi Germany invaded France. How? It began by going around the Maginot Line, through Belgium, Luxembourg and the Netherlands with highly mobile forces. The French believed they were facing a repeat of Germany's World War I strategy, the Schlieffen Plan, and moved most of its troops to the Low Countries to face the threat. They were confident their right flank was secured by the Maginot Line.

The Germans surprised the French and allied forces when it simultaneously assaulted the weakest section of Maginot Line that was directly opposite the Ardennes, a dense and rough forest that French military planners assumed was too difficult to traverse with tanks.

Not only did the German traverse the Ardennes with thousands of tanks and mechanized infantry, but with the use of mobile tactics, quickly defeated the defenses of the Maginot Line. Once in French territory, German tanks swung North and encircled Allied forces, trapping them against the English Channel.

Six weeks after the invasion began, Germany conquered Belgium, Luxembourg, the Netherlands, and France. It had driven the majority of the British Expeditionary Forces into the sea and captured sixty French and two British divisions. It was a stunning defeat, and the entire world was shocked.

How could the Germans make quick work of such formidable defenses?

To begin with, French leadership thought a second war with Germany would look much like the first. They took their experience from WWI and extrapolated it to WWII. They failed to account for new technologies and, more importantly, new applications of existing technologies.

It's a mistake to think that the French were clueless. They weren't. There was much debate within the top military brass during the 1920s whether to pursue a fixed-defense strategy or a mobile strategy based on armor and aircraft. However, they did not anticipate how the Germans would use their tanks: by concentrating them in massive numbers and having them overrun their defenses, advancing before French forces were even neutralized, creating havoc and confusion.

In contrast, French military doctrine envisioned tanks spread out among the infantry divisions and taking on a supporting role. Even though French tanks were technically superior to their German counterparts, French forces were quickly overwhelmed.

A Teaching Moment

The business world is filled with the corpses felled giants that once seemed invincible — an expensive education, free for anyone paying attention.

In 2013, 3G Capital and Berkshire Hathaway acquired control of H.J. Heinz for $23 billion and then funded the acquisition of Kraft Foods, creating the behemoth now known as Kraft-Heinz, the fifth-largest food company in the world.

3G Capital had been spectacularly successful using a simple formula: acquire well-known consumer brands with "wide moats", at a premium if necessary. Finance the acquisition with cheap debt. And operate the business as efficiently as possible.

3G's portfolio includes Anheuser-Busch InBev, Restaurant Brands International, and now Kraft Heinz. These monster companies operate in vast international markets and control an enviable collection of leading brands in each one. Yet all three face strong headwinds from changing consumer tastes as young millennials shift to craft beer, healthy restaurants, and fresh foods. All their "moats" are still there: strong brands, large and efficient distribution networks, deep pockets, and large marketing budgets. Smaller, nimbler brands are merely innovating around these.

Jorge Paulo Lemann, a co-founder of 3G and board member of its three largest investees mentioned above, addressed this issue head-on at a conference in 2018. "I'm a terrified dinosaur," he said. "I've been living in this cozy world of old brands and big volumes."

"We bought brands that we thought could last forever." He added: "You could just focus on being very efficient…". But things turned out to be a little more complicated. "All of a sudden, we are being disrupted."

Kraft-Heinz isn't going bankrupt, but it did take a $15.4 billion write-down on its acquisition of Kraft Foods and Oscar Mayer, it cut its dividend by 36% and is being investigated by the SEC regarding its accounting practices. 3G Capital and Berkshire Hathaway each took billion-dollar write-downs.

Was it worth paying a "moat premium"?

Was there a lesson here?

Where they exist, moats don't last forever. Sooner or later, new technologies will emerge, parallel markets will develop, and new competitors will find novel ways of doing things.

Companies that do have an economic moat tend to sell for higher valuations, which reduces investor's margin of safety. The underlying business must perform as implied by their high multiples; it must continue to earn above-market returns and, crucially, the market must continue to pay a high multiple for the company's shares. If any of these conditions are not met, investors will lose money or, in the best of cases, earn lower returns than those earned by the business itself.

Investing is hard

Do you think this is a one-off? It's not. If anything, the pace of change is increasing as new technologies, new industries and new markets develop. Investing has always been hard, and it's going to get even more challenging in the future.

A simple thought experiment:

Imagine it's the year 2000, and you somehow predicted, with 100% certainty, the rise of the internet and, later, the rise of mobile technology. What companies would have you acquired as the likely beneficiaries of these new markets? AOL? AT&T? IBM?

The dominant players of 2000 are barely relevant today, and it was impossible to foresee who the winners would be because they either did not yet exist or were unknown start-ups in a garage. New parallel industries can make the old, established industries less relevant.

This is not new. It has happened many times over. The only difference is that it now happens more often and more quickly. Think about what airlines did to rail and shipping lines or what mobile networks did to fixed-line telephone networks. The list of examples goes on.

Above and beyond the rapid pace of change and disruption, artificially low interest rates and Quantitative Easing are distorting markets and price discovery.

Are moats overrated?

Not really. From an operational perspective, moats are invaluable. And it can be argued that a company with a real moat does deserve a valuation premium.

It's not that they are overrated but that they are "over-spotted." Most investors pay for moats that aren't there because very few companies have real ones, and the ones that do, only do so temporarily.

When a company enjoys consistently superior returns over the rest of the industry, it attracts new players and imitators. The increased competition depresses margins and, eventually, returns reverse back to the mean.

Moats are overrated in the sense that they are not necessary to earn significant returns.

We have reviewed countless companies, both public and private, that thrive with no moat, only plain-vanilla competitive advantages. One example is a company that produces disposable wares for parties. It has no patents; it uses off-the-shelf technology and has no brand per se. Yet, it is immensely successful. Is it sustainable? As long as the business is run by its passionate founder and his great team, we believe the company is likely to build on its success and prosper.

The only real moat is culture

A good culture allows companies to do the essential thing for survival: adapt. Companies that can adapt to changing trends or even innovators that set trends are most likely to survive and thrive. I can think of no better example than Apple after Job's return in 1996. People want to work for Apple. People want to own Apple products and use Apple services. But those products and services have changed over time, and Apple adapted and morphed into a completely different company. Apple's revenue from services, such as App Store, Apple Music and Apple-Pay, reached $13.4 billion in the three months ended March 28, 2020. That's close to a quarter of its revenue. This from a company that "makes computers."

Apple certainly has excellent leadership, which is necessary for a great culture. But after Job's passing away, things did not break apart, and the company continues to grow, prosper and generate tons of cash flow. Its culture allowed it to adapt to management changes, to transition to new business models, and continue to thrive.

The problem is that culture is a soft subject that is shunned by most investors. It's impossible to quantify and hard to nail down as an outside investor. But there are windows into a company's culture that investors can use.

Price is always important

If price is the primary source of a margin of safety in investing, it makes little sense to pay-up too much for a moat, if it's there in the first place. Paying a premium reduces the margin of safety and can even eliminate the upside from growth.

Paying a premium for a moat means you run the risk that that precious moat disappears. Kraft-Heinz is a perfect example of a company with a wide moat. But just like pre-WWII France, Kraft-Heinz's moat does nothing to protect it from changing consumer tastes. New and nimbler competitors are merely going around Kraft's moat and taking market share.

As the study of drivers' self-assessed skills, not all businesses can be above average. But most of the time, that's ok.