In 2018, Elon Musk called out Warren Buffett’s concept of the importance of a moat for a business in the modern era going so far as to call them “lame.” Buffett was given a chance to explain his opinion on this comment from Musk at the following Berkshire Hathaway shareholder meeting. Let’s see what Buffett meant when he said a business “moat” and both sides of this rare exchange between legends in the business world.
What does Buffett say about a company’s moat?
“A truly great business must have an enduring “moat” that protects excellent returns on invested capital.” – Warren Buffett
“The most important thing in evaluating businesses is figuring out how big the moat is around the business,” prophesized Warren Buffett in 1991.
The “moat” he is explaining through metaphor is a competitive advantage and edge that makes a business unique, the best in its industry, and makes it difficult to compete with due to the barrier to entry to go after their market share.
Elon Musk Vs Warren Buffet
At Berkshire Hathaway’s 2018 Annual Shareholder’s Meeting Warren Buffett was asked directly about Elon Musk’s comment that “Moats Are Lame.” here was Buffett’s response.
Andrew Ross Sorkin asked, “This question comes from Kiwi and actually is directly about the issue of moats he notes that Elon Musk this week on the Tesla earnings call said the following quote, “I think moats are lame, they are like nice in a sort of quaint vestigial way and if your only defense against invading armies is a moat you will not last long. What matters is the pace of innovation that is the fundamental determinant of competitiveness, unquote.”
Andrew Ross Sorkin continued, “So, Warren, it seems the world has changed; business is getting more competitive, pace of innovation technology is impacting everything is Elon, right?”
Charlie Munger responded, “Warren does not intend to build an actual moat.
Warren Buffett added, “Even though they’re quaint. There’s certainly a great number of businesses this has always been true, but it does seem like it the pace accelerated and so on in recent years. There’s been uh more modes that have been become susceptible to invasion. You certainly should be working at improving your own moat and defending your own moat all the time, and then Elon may turn things upside down in some areas. I don’t think he’d want to take us on in candy, and we’ve got some other businesses that wouldn’t be so easy. You can look at something like Garanimals out there in the other room, and it won’t be technology that takes away the business in Garanimals it may be something else that catches the young kid’s fantasy or something, but there are some pretty good moats around. Being the low-cost producer, for example, is a terribly important moat and something like Geico. Technology has really not brought down the cost that much, and I think our position as there are a couple of companies that have costs as low as ours, but among big companies we are a low-cost producer, and that is not bad when you’re selling an essential item.”
Why Warren Buffett thinks moats are so important
One of Warren Buffett’s favorite metaphors for business and investing – is the concept of economic “moats.” Back in medieval times, castles had moats – wide, deep ditches filled with water – as a form of protection against invaders. It was an effective defense, making it difficult for adversaries to breach the castle walls.
Now, think about a business as if it’s a castle. The business world is full of competition, so a business must have its form of a moat – an economic moat, to be exact. This moat is a unique competitive advantage that protects the business from its rivals, allowing it to sustain its profitability over the long term. It could be a superior brand, a cost advantage, a network effect, high switching costs, or even patents and licenses.
A business with a wide economic moat will likely withstand the onslaught of competition, just like a well-defended castle. These are the kinds of businesses Buffett loves in investing because they are more likely to maintain or even expand their profit margins over time. This leads to increased profits and potentially higher stock prices, which investors like Buffett and Munger, like to see.
But remember, it’s not just about identifying these moats; it’s also about understanding their durability. Understand, the world is always changing, and competition never sleeps. Technology can evolve, consumer behavior can shift, and regulation can change. All of these things can have an impact on a business’s moat.
So, as an investor, you not only want to find a company with a wide moat but also try to understand whether that moat can withstand the test of time. Will it be able to fend off competitors and maintain its profitability in the years to come? That’s the most important question.
Just remember – moats matter. Always look for them when scouting for businesses to invest in. But also consider their strength and longevity. That’s one of the ways to approach investing if you want to have a good shot at doing well.
What are the 5 economic moats?
Let’s dig a bit deeper into these five types of economic moats that a business might have:
- Cost Advantage: This is when a company can produce and deliver its products or services at a lower cost than its competitors. This could be due to economies of scale, superior process efficiency, or access to cheaper raw materials. These companies can then undercut their competition on price, boosting their market share or maintaining industry-level prices and enjoying a more considerable profit margin.
- Intangible Assets: These are non-physical assets that add value to a company, including brand recognition, patents, trademarks, copyrights, and government licenses. A strong brand, for example, can command customer loyalty and charge higher prices. Patents can protect a company’s unique products from being copied by competitors, ensuring it remains the sole provider.
- High Switching Costs: This exists when it’s costly, inconvenient, or disruptive for a customer to switch to a competitor’s product or service. Software companies often have this type of moat. For example, once a business integrates a certain software system into its operations and employees are trained to use it, changing to a different system becomes quite expensive and bothersome. This can create long-term, stable customer relationships.
- Size Advantage: This refers to the idea that larger companies can have competitive advantages over smaller ones. They can negotiate better terms with suppliers, spread fixed costs over a more extensive revenue base, and use their resources to undercut prices or invest in new areas. A good example is Walmart, which can negotiate low costs from suppliers due to its massive purchasing volume.
- Soft Moats (Network Effect): This moat occurs when a product or service becomes more valuable as more people use it, creating a positive feedback loop. Social media platforms like Facebook or transaction platforms like eBay are examples where the network effect is in play. The more users a platform has, the more attractive it becomes to new users, as they have more people to connect with or more products to buy and sell.
It’s important to remember that these moats can overlap, and many successful businesses possess more than one type. Additionally, it’s critical to consider whether these moats are sustainable over the long term, as a moat that deteriorates over time could expose the business to increased competition.
Warren Buffet has used “moats” as one of his most essential filters for choosing what stocks to buy and what companies to acquire for Berkshire Hathaway. Elon Musk thinks “moats” are lame and focuses instead on building rockets.