Building a framework for measuring the moat
It is of utmost importance for an investor to know the concept of competitive advantages, what Warren Buffett refers to as a moat. Another dimension that also is imporotant is the sustainability of any competitive advantages identified.
A great way to improve knowledge in this area is to read the report Measuring the Moat – Assessing the Magnitude and Sustainability of Value Creation written by Michael J. Mauboussin and Dan Callahan, both currently at Credit Suisse.
A few glimpses of the content of the report is found on the front page:
- Sustainable value creation is of prime interest to investors who seek to anticipate expectations revisions.
- This report develops a systematic framework to determine the size of a company’s moat.
- We cover industry analysis, firm-specific analysis, and firm interaction.
The first part of the report is a summary of the topics discussed in it. This section is included below.
- Sustainable value creation has two dimensions—how much economic profit a company earns and how long it can earn excess returns. Both dimensions are of prime interest to investors and corporate executives.
- Sustainable value creation as the result solely of managerial skill is rare. Competitive forces drive returns toward the cost of capital. Investors should be careful about how much they pay for future value creation.
- Warren Buffett consistently emphasizes that he wants to buy businesses with prospects for sustainable value creation. He suggests that buying a business is like buying a castle surrounded by a moat and that he wants the moat to be deep and wide to fend off all competition. Economic moats are almost never stable. Because of competition, they are getting a little bit wider or narrower every day. This report develops a systematic framework to determine the size of a company’s moat.
- Companies and investors use competitive strategy analysis for two very different purposes. Companies try to generate returns above the cost of capital, while investors try to anticipate revisions in expectations for financial performance. If a company’s share price already captures its prospects for sustainable value creation, investors should expect to earn a risk-adjusted market return.
- Industry effects are the most important in the sustainability of high performance and a close second in the emergence of high performance. However, industry effects are much smaller than firm-specific factors for low performers. For companies that are below average, strategies and resources explain 90 percent or more of their returns.
- The industry is the correct place to start an analysis of sustainable value creation. We recommend getting a lay of the land, which includes a grasp of the participants and how they interact, an analysis of profit pools, and an assessment of industry stability. We follow this with an analysis of the five forces and a discussion of the disruptive innovation framework.
- A clear understanding of how a company creates shareholder value is core to understanding sustainable value creation. We define three broad sources of added value: production advantages, consumer advantages, and external advantages.
- How firms interact plays an important role in shaping sustainable value creation. We consider interaction through game theory as well as co-evolution.
- Brands do not confer competitive advantage in and of themselves. Customers hire them to do a specific job. Brands that do those jobs reliably and cost effectively thrive. Brands only add value if they increase customer willingness to pay or if they reduce the cost to provide the good or service.
- We provide a complete checklist of questions to guide the strategic analysis in Appendix A.