You have Discovered Product/Market Fit. What about a Moat?

I have previously written blog posts about (1) growth, (2) product/market fit and (3) minimum viable product. The most logical topic for the next post is: Why does a business need a moat? The answer is simple: even if a business discovers solutions to the value hypothesis and the growth hypotheses without a moat the probability of the business being financially successful over time is remote. Revenue alone is not enough to sustain a business given the inevitable competitive response. A sustained return on invested capital is a prerequisite for the long-term survival of a business. In other words, “for what shall it profit a business, if it shall discover solutions to the value a growth hypotheses, but fail anyway because it does not have a moat?” At worst, the business without a moat is never profitable (like Fab.com). At best, the business without a moat is profitable for a while, but over time is gradually overtaken (as may be happening right now to GoPro).

Questions about the creation, maintenance and destruction of moats are the most fascinating and challenging aspects of business and investing. This is true because what Joseph Schumpeter called “creative destruction” is more powerful than any phenomenon in business. Michael Mauboussin says it best: “Companies generating high economic returns will attract competitors willing to take a lesser, albeit still attractive return, which will drive aggregate industry returns to opportunity cost of capital.”

The moat creation and destruction process is similar to what happens during evolution in nature. What’s an example of a specific moat analogy from nature? The sword-billed hummingbird is a species from South America. The bird’s very long sword-like bill acts as a moat against competitors by allowing it to reach a unique source of nectar from long-tubed passion flowers.

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Why did I select this hummingbird to illustrate my point? First I wanted to leverage the fact that you may have recently watched one notable episode the BBC’s Planet Earth series. Second, while the humming bird has a moat due to its long beak, the bird’s market is limited to a small number of flowers in a relatively small territory. Some moats are operative in small markets and some are big. Twitter’s moat may only protect something that generates $600 million a quarter in revenue, which some people might consider to be relatively small like the hummingbird’s territory. Or Twitter’s revenue may grow much larger. Therein lies much of the fun and challenge in investing. As an aside, since I know you want to know, hummingbirds do tweet.

Mistakes are easy to make when trying to make predictions about moat strength, value and duration. For example, even if a business currently has a moat, that does not mean it will continue to do so for very long. Some businesses were at one point very highly valued since investors mistakenly thought they had a strong moat in a large and valuable market. GoPro would seem to be an example:

gopro

Predicting the future of a moat is so hard because the markets in which they operate are complex and adaptive. I wrote about why it is hard to predict the future in this post. Factors that can create a moat are constantly in flux and because they often interrelate to create nonlinear positive and negative changes. An example of negative outcomes for a business from a shift in the strength of a moat is what happened to the newspaper industry when publishers lost their physical distribution-based moat.

Without a moat this can happen:

“There are all kinds of wonderful new inventions that give you nothing as owners except the opportunity to spend a lot more money in a business that’s still going to be lousy. The money still won’t come to you. All of the advantages from great improvements are going to flow through to the customers.” Charlie Munger

The point Munger just made so clearly is counter-intuitive for many people, but essential to understand. Moat creation is incredibly hard and rare and maintaining one is hard as well. It is a big mistake to confuse a moat shortage with an innovation shortage. Some innovation does not produce any profit and in fact can destroy profit. For every firm creating disruption, some other firms are being disrupted.

The test of whether a moat exists is quantitative, even though the factors that create moats are qualitative. If a business has not earned returns on capital that substantially exceed the opportunity cost of capital for three to five years, it does not have a moat.  That is quantitative. As for the qualitative side of this topic, there are no formulas or recipes that govern the creation and sustainability of moats, but there is enough commonality that you can get better at understanding how they are created and whether they can be maintained over time. Charlie Munger told Howard Marks once: “It’s not supposed to be easy. Anyone who finds it easy is stupid. There are many layers to this and you just have to think well.” The existence and need to understand the many layers Munger is talking about explains why there are so many different posts on this blog. And why Warren Buffett believes that business is the most interesting game ever invented. The need to “learn more about more” never ends. Ever. What are these “layers” that Munger is talking about?  Marc Andreessen puts it this way:

“I have always been a fan of something that Andy Rachleff taught me years ago, which he calls the onion theory of risk. Which basically is, you can think about a startup like on day one, as having every conceivable kind of risk and you can basically make a list of the risks. So you’ve got founding team risks, are the founders going to be able to work together; then you have product risk, can you build the product; you will have technical risk, maybe you need a machine learning breakthrough or something. Are you going to have something to make it work, or are you going to be able to do that? You will have launch risk, will the launch go well; you will have market acceptance risk, you will have revenue risk. A big risk you get into with a lot of businesses that have a sales force, is that can you actually sell the product for enough money to actually pay for the cost of sales? So you have cost of sales risk. If you are a consumer product, you have viral growth risk. So a startup at the very beginning is just this long list of risks, right, and the way I always think about running a startup is also how I think about raising money. Which is a process of peeling away layers of risk as you go.”

Among the risks Andreessen talks about are technology, product, market, competition, timing, financing, distribution, marketing, hiring and founder. Each must be retired at some point by the business. The existence of a moat is critical to reducing competition risk. In my blog post on Eugene Kleiner I quote him as saying“Risk up front, out early.” A famous venture capitalist said to me that Kleiner: “Always had a strong bias for eliminating the biggest risks quickly, which was much more relevant in the days of backing companies with high technical risk and low market risk.” Another famous VC who knew Kleiner well wrote to me that what he meant by this sentence was: “Reduce the biggest risks first for the fewest dollars. This may mean out of order execution to minimize loss in case of failure.”

I view the great moat creators of the world as artists. When someone like Rich Barton creates or is involved in the creation of successful business after successful business (Expedia, Zillow, Glassdoor, Avvo, Realself, Nextdoor) when the failure rate for startups is as high as it is, I can’t help but be impressed. Bill Gates created several moats for different product as did Steve Jobs. When someone does something repeatedly you can be assured that the skill to luck ratio weighted strongly toward skill.  One point is clear from the numbers (AKA, empirical evidence): moat creation in a really large and valuable market is rare event. This must be the case since the number of financial exits is top-down constrained by the size of the economy and its ability to absorb profitable new businesses. Venture-backed businesses overwhelmingly fail financially as I wrote in my post last week on minimum viable products.

The major factors that can create a moat are:

  1. Demand-side Economies of Scale

Demand-side economies of scale (also known as “network effects”) result when a product or service becomes more valuable as more people use it. Microsoft, Amazon, Google, Facebook and other multi-sided markets have demand-side economies of scale that operate on their behalf. Network effects represent the most valuable factors creating a moat since the benefits of demand-side economies of scale can increase in business value a nonlinear manner, especially in software businesses. Moats created by network effects are vastly more scalable than other types of moats. This means that the benefits realized by the major software-based platforms are far larger than those realized by a large steel or cement producer based on supply-side economies of scale. Network effects are extremely hard to create and, as Blackberry found, can be very brittle.  Of all the factors that can create a moat, nothing is more important than network effects in my view. A great example of the value of network effects are Bloomberg terminals. The more people who use these terminals the more valuable they become to other users. The FT writes:

“Bloomberg’s pioneering instant messaging and chat rooms, not data or news, are arguably one of the biggest drivers of its dominance. The bond market — where trading mostly happens discreetly between fund managers, brokers and banks, rather than on bourses — is particularly dependent on the Instant Bloomberg messaging function. But “I’ll IB you” has become lingua franca across the financial world. The dominance of Bloomberg chat is a significant “economic moat” for the company.”

  1. Supply-side Economies of Scale

A business generates supply-side economies if per-unit costs fall with increasing output. Economies of scale, with a few rare exceptions, are exhausted well before businesses dominate the entire market.” For example, despite having significant supply-side economies of scale, General Motors never was able to obtain 100% market share. Costco has supply side scale economies of scale that help create its moat, but it is not even the only warehouse club in terms of market share. Costco is nevertheless a hugely valuable business that is Charlie Munger’s favorite business after Berkshire Hathaway. Both Amazon AWS and Microsoft Azure have supply-side economies of scale that benefit their business.

  1. Brand, Patents and Intellectual Property

Charlie Munger and Warren Buffett discovered soon after they bought See’s Candies that they could regularly raise prices and customers did not seem to care. Buffett and Munger call this ability “pricing power.” Charlie Munger has pointed out that before See’s Candies: “We didn’t know the power of a good brand. Over time we just discovered that we could raise prices 10% a year and no one cared. Learning this changed Berkshire. It was really important.” People do conduct surveys and try to rank brands which is in my view is the equivalent of guessing.

braaand

A patent or other form of intellectual property like trademarks or copyrights can create a moat. Qualcomm is an example of a company that has created a moat mostly via intellectual property. Open source makes moats on some areas of the software business problematic. Proprietary software kept secret in a server does not need to have the same intellectual property protection as client side software.

  1. Regulation:

There are certain businesses which have created a competence with regard to regulation that is so high that regulation serves as a moat. As an example, lawyers and other professional are able to reduce supply and create a moat through regulation. As an example, having the regulatory expertise to qualify to do business as a web services provider on a global basis on behalf of customers is a form of moat.

Can great management or better business execution create a moat? Warren Buffett’s famous quip on that point is: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Professor Michael Porter agrees: “It’s incredibly arrogant for a company to believe that it can deliver the same sort of product that its rivals do and actually do better for very long.” Competition will in that case eventually be based on price and price-based competition inevitably degrades to a point where profit disappears. This is not to say that great management is not highly valuable. It is. But people like Buffett and Porter believe it isn’t enough to reliably sustain profitability over long periods of time. Some companies which execute operationally have a great run of success but eventually fall victim to competition catching up with best practices.  Buffett puts it this way: “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”

Notes:

Mauboussin- Measuring the Moat https://doc.research-and-analytics.csfb.com/docView?language=ENG&format=PDF&sourceid=em&document_id=1066439791&serialid=RojFyPPuyB52GjdsfOiNhlbEB2L63HISLZqSTpL1p48%3d

A Dozen Things I’ve Learned from Charlie Munger about Moats https://25iq.com/2015/10/10/a-dozen-things-ive-learned-from-charlie-munger-about-moats/

Lecture 9 How to Raise Money https://genius.com/Marc-andreessen-lecture-9-how-to-raise-money-annotated

FT on the Bloomberg Terminal:  https://www.ft.com/content/5d6c2d9c-1f61-11e5-ab0f-6bb9974f25d0

Eugene Kleiner https://25iq.com/2016/07/08/a-dozen-things-ive-learned-from-eugene-kleiner-about-investing-and-business/

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