Warren Buffett popularized the term “moat”, or “economic moat”, as a way of describing an advantage, or protection, a business has over its competitors. He believes that the size of the “moat around a business” tells a lot about how viable the business will be as time goes by.
Here is how Buffett describes a moat:
“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 you need a knight in the castle who is trying to widen the moat around the castle.
There are some businesses that have very large moats around them and they have crocodiles and sharks and piranhas swimming around them. Those are the kinds of businesses you want.”
I love the moat analogy. It does such a great job of capturing the importance of working proactively to protect your business from the competition. The moat is a symbol for the work you have done to make it difficult for the enemy to come after your customers and your profits. If you look at your business as an “economic castle”, then you have an obligation and a duty to protect it from those who might do harm to it.
A moat, or competitive advantage, could be a cost advantage, a size advantage, a quality or unique product advantage, a brand loyalty advantage, a service advantage, etc. It is something that gives your company an advantage over other competitors in the marketplace. It is important to note that the advantage should manifest itself in an “economic” benefit in that the company should generate above average profitability and cash flow resulting from the moat (the competitive advantage).
The Purpose of a Moat
The ultimate purpose of having, and expanding, an “unbreachable moat” is to create a financially successful business. A strong business that produces excess cash for its owners. A business that has a bright future as far as the eye can see.
Here is a quote from Buffett on the importance of a business generating excess cash for its owners:
“The reason we invest in an economic asset like a business, apartment building, farm, or bond is to make money. But what does that mean? [The answer is] How much cash do I get and when do I get it?”
… a financial asset [a business] has to give you back a lot more cash one day in order to justify your laying out cash for it now. No matter whether a company makes telecom equipment, cars, or candy, it’s still the same question: How much cash do we get and when?”
Charlie Munger, Buffett’s longtime business partner, said:
“For years, I was a director of an International Harvester dealership… That is a really tough business. And there’s never any cash. As the saying goes, at the end of the year, your profit is sitting out in the yard – in the form of used equipment [inventory].
Struggling with a business that never produces any cash… is no fun.”
Buffett echoed that same sentiment when he said:
“Our acquisition preferences run toward businesses that generate cash, not those that consume it… You don’t want a business that’s like a horse that never runs, but eats.”
Amen to that. 😊 You can’t create Happy Owners if your business never generates any excess cash.
GEICO as an Example
Buffet says this about the economic moat that his company GEICO has created over time:
“One of the best moats in many respects is to be a low-cost producer. Being a low-cost producer of something that’s essential to people is going to be a very good business usually.
We’re the lost-cost producer at GEICO in auto insurance among big companies. They buy brilliantly, they operate at expense ratios competitors don’t even dream about, and they then pass on to their customers much of the savings. It’s the ideal business – one built upon exceptional value to the customer that in turn translates into exceptional economics for its owners.
When a company is selling a product with commodity-like economic characteristics, being the low-cost producer is all-important.”
How Strong is Your Moat?
Buffett says that one of the tests of the strength of a company’s economic moat is its “pricing power”.
“If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising prices by a tenth of a cent, then you’ve got a terrible business.”
Any time you can charge more for a product and maintain or increase market share against well entrenched, well known competitors, you know that you have something very special in people’s minds. You can almost measure the strength of a business over time by the agony its managers go through in determining whether a price increase can be sustained.
You can learn a lot about the durability of the economics of a business by observing the price behavior.”
Widening the Moat
Warren Buffet spoke to the importance of constantly “widening the moat” around a business in his 2005 Letter to Shareholders:
“Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger. If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither. On a daily basis, the effects of our actions are imperceptible; cumulatively, though, their consequences are enormous.
When our long-term competitive position improves as a result of these almost unnoticeable actions, we describe the phenomenon as “widening the moat.” And doing that is essential if we are to have the kind of business we want a decade or two from now. We always, of course, hope to earn more money in the short-term. But when short-term and long-term conflict, widening the moat must take precedence.”
Lessons for Your Business
I believe the concept of an “economic moat” is something we should all think about regardless of the size of our business. Here are three areas or questions to think through:
- Do we have a moat around our business?
- How can we widen our moat?
- Is our moat helping us create Happy Owners (by generating above average profits and cash flow)?
Let’s look at each area/question.
- Do we have a moat around our business?
What would you say is your primary competitive advantage? Why do customers choose your business over the competition? Are you the lost-cost producer? Do you provide a product or service that is unique? Do you raise your prices regularly without losing business to a competitor? Or do you have to “have a prayer session before raising prices” by even the smallest amount? Think through some of the strengths of your company to see if you can identify what contributes to the moat that surrounds your “economic castle.”
- How can we widen our moat?
After you identify the qualities of your moat, you want to begin thinking about whether your moat is getting stronger or getting weaker. And you want to make sure that your Monthly Financial Rhythm includes financial goals and targets designed to “widen your moat” over time.
Buffett says “What should you be doing in running your business? Just what you always do: Widen the moat, build enduring competitive advantage, delight your customers, and relentlessly fight costs.”
- Is our moat helping us create Happy Owners (by generating above average profits and cash flow)?
When your business provides “exceptional value to the customer” then you are well on your way to creating Happy Customers. A Happy Customer is a customer that loves your products and services, is happy with your prices, comes back often, and refers their friends and colleagues to your business.
Creating Happy Customers then “translates into exceptional economics for its owners.” Which means that creating Happy Customers puts you well on your way to creating Happy Owners. A Happy Owner is a business owner that receives healthy and regular distributions of excess cash, is happy with the level of company profits, supports the company’s plan to reinvest and make the company stronger each year, and has confidence in the financial future of the company.
Here are some financial (economic) questions to ask yourself:
- Are you a Happy Owner?
- Is your business generating excess cash?
- Are you as profitable as you should be (or want to be)?
- Is the value of your business going up or going down?
As you think about these questions, especially the one about profitability, keep in mind that sometimes our short-term need for profits will conflict with what we should be doing to make our business strong for the long-term.
I have learned over the years not to get overly focused on profits in any given year. I have witnessed firsthand how important it is to “widen the moat” in some years… even if it means accepting lower profits for the year.
Having said that, it is true in business that above average profits and strong cash flow are the foundation for financial success in business. Generating healthy profits is critical.
I encourage you to compare your profitability to industry data in this link to a fun, interactive dashboard. Comparing your profitability with other businesses gives you a sense for whether your business is as profitable as it should be (or could be). It is not an exact science, or a perfectly apples-to-apples comparison. But it can give you a general sense of whether now is the time to put an additional focus on driving your profitability and cash flow higher in your business.
This 5-Minute Profitability Assessment will help you too.
How Wide is Your Moat?
Stop for a minute and think about whether you have a moat around your business. And whether your moat is stronger, and wider, today than it was last year. If it isn’t, then maybe now is the time to set financial goals and targets that will help make your business strong and healthy into the future.
Creating sustainable financial success in your business is an all-important benefit of working to widen your moat over time. As your business gets better and better at generating excess cash, it provides the capital you need to continue to grow and expand your business. It gives you the money to make your product better and better for customers. It provides the money to ensure your employees are well-paid and have the tools and technology they need to serve customers.
You will be creating what Buffett describes as a great business rather than just a good, or even gruesome, business. You will have a business that will “give you back a lot more cash one day in order to justify your laying out cash for it now.”
Buffett said: “In business, I look for economic castles protected by unbreachable moats.”
- Are you working on turning your business into an economic castle?
- Are you working on creating an unbreachable moat to protect your economic castle?
Here’s to success in widening your economic moat and generating above average profitability and cash flow this year. 😊
Note: The source for the quotes from Warren Buffett and Charlie Munger are two books, both by Peter Bevelin. The first book is All I Want To Know Is Where I’m Going To Die So I’ll Never Go There: Buffett & Munger – A Study in Simplicity and Uncommon, Common Sense.
The other book is Seeking Wisdom: From Darwin to Munger. Both books are fantastic. The author does an amazing job of bringing Warren Buffett and Charlie Munger quotes together along specific topics that helps you quickly digest the wisdom and learning that Buffett and Munger have to offer.
Philip Campbell is an experienced financial consultant and author of the book A Quick Start Guide to Financial Forecasting: Discover the Secret to Driving Growth, Profitability, and Cash Flow and the book Never Run Out of Cash: The 10 Cash Flow Rules You Can’t Afford to Ignore. He is also the author of a number of online courses including Understanding Your Cash Flow – In Less Than 10 Minutes. His books, articles, blog and online courses provide an easy-to-understand, step-by-step guide for entrepreneurs and business owners who want to create financial health, wealth, and freedom in business.
Philip’s 30 year career includes the acquisition or sale of 33 companies (and counting) and an IPO on the New York Stock Exchange.
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