3D Competitive Moat Analysis
Exploring the unified framework of capacity, trajectory, and durability
Competitive moat analysis is the focal point of research efforts by fundamental investors, particularly those with a quality orientation. Given the importance of this component of investment due diligence, there have been many notable contributions to the field from investors over several decades. Philip Fisher arguably created the concept of quality investing based on observable competitive advantages, but Warren Buffett has served as the primary thought leader that popularized thinking about and investing in businesses with wide competitive moats. In the wake of Warren Buffett have been additional ideological contributions from Pat Dorsey, WCM Investment Management, and Nicholas Sleep. While everyone noted previously (although these contributors are not exhaustive) has added genuine understanding to the field of competitive analysis, there is, to my knowledge, no published synthesis of all of these contributions into a unified system of competitive moat analysis. This essay is an attempt at such an endeavor. Consequently, I propose that a complete understanding of a company’s competitive moat necessitates understanding its Capacity, Trajectory, and Durability. I will define each of these individual terms and discuss the importance of them as well as provide examples of why they merit deployment in competitive moat analysis.
1) Capacity
The capacity of a company’s competitive moat is the absolute size of its advantage relative to peers. By way of analogy, if a competitive advantage is equivalent to the walls of a castle, then capacity is the height of the walls. The higher the walls, the bigger the competitive advantage. The original insight of Phil Fisher and Warren Buffett was to look for businesses with superior quantitative financial metrics such as growth rates, margins, and returns on invested capital that evidenced a qualitative understanding of a business’ competitive advantage, and then contextualize these superior results in comparison to peers as proof that the moat produced superior outcomes.
Buffett took this a step further and began identifying specific moat typologies, like brands and cost advantages, leading to investments in Coca-Cola and GEICO. He also called out natural monopolies like railroads and utilities as businesses with strong competitive moats, accompanied by investments in MidAmerican Energy and Burlington Northern Santa Fe. Balance sheet strength was another form of competitive advantage that Berkshire cultivated in its supercat insurance business.
Pat Dorsey has added to Buffett’s initial list of moat typologies, suggesting moats as derived from intangible assets (not just brands, but also patents and regulatory licenses), switching costs, and network effects, while also expanding the discussion on cost advantages to highlight structural realities based on process, location, scale, or unique access to a resource, all in contrast to business efficiency.
Now, the capacity of a competitive moat is a primary factor that requires analytical energy during the investment process, but it’s incomplete on its own. The main reason that capacity fails to fully inform investors is that it’s a point-in-time determination that’s evidenced primarily through historical financial data, adding a backwards looking bias. As a result, investors focusing solely on capacity can often invest in businesses that are at the height of their economic performance but are positioned to encounter disruption that will destroy a company’s competitive advantage in the future. Buffett has seen this firsthand as The Washington Post and Buffalo News were wonderful businesses in the 1970s and into 1990s, but have been entirely eclipsed by social media and other digital platforms and the eyeballs they attract, leading to dismal economic performance from the 2000s into the present. What’s needed to address this weakness of capacity analysis is a forward-looking perspective on a company’s competitive moat, which I will now turn to.
2) Trajectory
It’s perhaps unfair to say that Warren Buffett took a completely static view of evaluating competitive moats, as he repeatedly referred to businesses with widening moats as his favorites across Berkshire’s annual letters. Nevertheless, his public thinking never developed to the point of evaluating the direction of a company’s competitive advantage – or its trajectory as coined by WCM Investment Management – as a distinct component. WCM is the leading proponent of moat trajectory investing, having written and discussed this topic extensively, and their thinking has been supplemented by Morningstar, which has referred to moats as either widening, narrowing, or eroding in its research.
At this point, it should come as no surprise that the question of moat trajectory analysis is understanding whether a company’s competitive position is improving, stable, or weakening. To continue the castle wall analogy, the trajectory of a company’s competitive advantage is akin to the walls getting higher, lower or staying the same height over time. In other words, the qualitative insights derived from moat trajectory assessment serve as the leading indicators of a company’s financial metrics, such that growing moats should indicate increasing margins and returns on invested capital, and shrinking moats suggest lower margins and returns on invested capital in the future. This point of analysis is directly aimed at avoiding the mistake of investing in companies that are facing negative competitive headwinds, especially when the stock has sold off when quantitative financial metrics still look good, a situation that is consistent with the beginning of a classic value trap.
The trajectory of a company’s competitive moat is a function of both internal and external factors. On the one hand, a company can expand its advantage, say by investing in more manufacturing capacity to increase a cost advantage, or by capturing more customers and improving network effects. Alternatively, restraining R&D investment and losing product functionality would indicate a company’s decision leading to a weakening advantage. Outside of the company, a business is faced with the decisions of its competitors, changes in industry structure, and secular changes that all impact the trajectory of its moat.
It would be difficult to capture all the potential actions of competitors that reduce a company’s moat, but developing new products, adding features, expanding manufacturing capacity, internalizing capabilities, or acquisitions can all impact a company’s moat. For example, Facebook effectively neutered Snapchat when the former business added the Reels video feature that closely mimicked the latter’s native content format, while Intel lost substantial market share when it chose not to develop mobile processors for Apple, handing TSMC the opportunity and eventual market leadership in logic chip production.
Changes in industry structure are some of the most powerful forces that impact a company’s moat trajectory but are often underappreciated in their ability to turn bad businesses into wonderful ones, or the reverse. For example, the consolidation of the computer memory market into three players, Samsung, Micron, and SK Hynix, has dramatically improved the economics of the sector. In contrast to that situation, the entrance of SpaceX and Amazon into the satellite internet business has substantially hurt the prospects of GoGo, who previously was the sole provider of internet for airplanes.
Another variation of industry structure changes worth noting is the amount of capital flowing into the industry as per Marathon Asset Management’s Capital Cycle theory, where positive economics attract capital and competition that reduces the returns for all market participants, while capital flowing out of a sector improves the economics for the remaining players. What’s interesting about capital cycle theory is that market structure can stay the same (i.e., no new entrants or exits), yet economics can deteriorate if capital increases production capacity across an industry in excess of demand (which is what typically happens), while returns on capital can improve in a dearth of new investment. The latter case has been evident in both the gold and copper mining sectors, where overinvestment in the mid 2010s led to a period of constrained incremental supply over the late 2010s and that subsequently resulted in exceptional returns on capital for miners as demand began to outstrip supply in the 2020s.
Finally, moat trajectory analysis needs to evaluate the secular changes going on in an industry that can disrupt entire business models for existing competitors or create entirely new category leaders from the enterprises that are driving the shifts in the external environment. The rise of digital content streaming is a perfect example of this dynamic, as Netflix’s usage of broadband internet to reach consumers directly with on-demand and ad-free content has destroyed the video rental business, while simultaneously putting most cable TV businesses on a path to irrelevance. Meanwhile, Amazon’s online shopping model across various categories allowed the company to become the world’s largest retailer as many physical retailers went bankrupt or shut down entirely. This dynamic of secular change was what Berkshire’s newspaper businesses faced as well, demonstrating that no matter how strong a company’s competitive moat is in the present, the winds of change are an inevitability for every business and a force that every investor must reckon with.
At this point, one might wonder whether the analysis of competitive moat capacity and trajectory should be sufficient for an investor to make informed investment decisions and avoid some obvious mistakes. Yet while trajectory clearly improves on capacity alone, there is one final piece that speaks to the inertia in competitive position that requires analysis to form a complete picture, a topic that I will now discuss.
3) Durability
If capacity is the size of the moat, and trajectory indicates what is happening to the size of the moat, then durability is how effectively a company’s competitive advantage is able to withstand the assault of competition. While capacity and trajectory look at qualitative factors that would discourage competition, durability is the lens that seeks to understand what happens when a company faces competition. Returning to the castle wall analogy, durability speaks to understanding what the potential outcome is when an assailant gets to the wall and starts attacking it; durable walls can withstand a sizeable amount of damage without being worse for wear, while non-durable walls quickly crack and fail to protect the inhabitants. Similarly, a company with a high durability moat can more easily repel and stymie the competitors attempting to woo customers and steal market share, and those with low durability moats are at much higher risk should the competitive landscape change. But to fully understand this concept, we’ll now look at what makes a moat durable or not.
To begin the discussion, I start with noting the concept of switching costs, and their ability to hamper new entrants. Switching costs are the very real amounts of money or time that customers need to spend to switch to an alternative. However, switching costs are more consistent with the capacity element of a moat, as they measure how much friction prevents customers from leaving, while durability measures whether customers would leave if friction disappeared. What durability strikes at the heart of is how much customers want to use a company’s product or service, rather than looking at how much they have to choose it. In other words, companies with high durability moats are those with strong customer loyalty, generally based on a management philosophy that aims to deliver more value to customers than what’s charged for, evidencing a customer-centric mentality.
Nick Sleep’s Robustness Ratio compared the amount of value or benefit provided to customers in comparison to the economic profit associated with that benefit. So, businesses that delivered more value to customers in proportion to the profits they generated were less prone to disruption given they gave more to their customers than they received in profit. In the example of Costco, management believed that every customer saved $5 in comparison to $1 of profit generated by the company, leading to a robustness ratio of 5. What Nick’s framework provided was a quantitative perspective that sought to identify whose customers wouldn’t leave even if they could, evidencing durability. My first principles approach to understanding the organizing principles of companies as part of the investment process also touched on durability by creating a perspective to identify companies and management teams that were actively building durability into their competitive advantage. We therefore see a company like Spotify evidencing a high durability moat through a relentless focus on customer engagement and a pricing strategy based on delivering more value to the customer than the price charged. In another example, ASML’s depth of technological innovation is all in service of improving the yield and throughput of its customers’ semiconductor production, while its customer-aligned pricing approach increases the company’s ability to withstand competitive pressure if its monopoly position were to erode.
The converse of a high durability moat is one with low durability. Businesses like this might have strong moats that are growing, but customers are only choosing this company’s offering because they have to. Businesses and consumers might need to use the product or service, but they certainly don’t enjoy buying or consuming it. This can result in low customer ratings or loyalty metrics, but it also shows up in how a company interacts with its clients. An example that helped bring this idea to life for me was Rightmove in the UK, the largest online real estate listing marketplace in that country. While the company is the dominant online marketplace for real estate agents to list properties on due to the amount of traffic it generates and therefore possesses an admirable moat that appears wide and stable due to a lack of viable alternatives, the feedback from real estate brokers paying for the service was almost uniform that they would all switch if they could. In other words, if a viable competitor arrived on the scene, the loss of customers would be an exodus rather than a trickle. Another example I came across was Shimano, one of the leading manufacturers of bicycle components, who used the guise of inflation during COVID to increase their prices to the maximum extent they could get away with, leaving a sour taste in their customers’ mouths.
What is unique about the moat durability perspective is that it assumes competition is inevitable and therefore tries to understand how quickly a company could lose its moat, or how long it would take a sustained amount of effort from a competitor to win the battle with a superior offering. In this framework, high durability moats can either eliminate competitive threats before they become material or slow the incursion down enough for investors to react before a business has fundamentally deteriorated. Meanwhile, low durability moats collapse under threat. Importantly, this perspective helps avoid the risk of investing in businesses where a moat decays faster than a moat trajectory analysis can assess the change in competitive reality.
Conclusion
While there are minimal new contributions to the field of competitive moat analysis in terms of the individual dimensions discussed previously, what has not been discussed to-date (to my knowledge) is an aggregation of these various spheres of analysis into a unified perspective to guide the qualitative assessment of a company’s business model and external environment. With many quality investors devoting significant energy to one of capacity, trajectory, or durability, only a minority contemplating two at a time, and none looking at all three simultaneously (except perhaps as an unconscious heuristic rather than as a formal, documented framework), it stands to reason that a unified theory of competitive moat analysis based on three dimensions of observation implies a differentiated perspective for any investor willing to deploy it in investment research and decision-making. Capacity on its own is backwards looking, trajectory can be overly sensitive to shifts in the competitive landscape, and durability can settle for unexceptional economics. As such, it’s only when an investor applies a holistic perspective to understanding a company’s moat by assessing the capacity, trajectory, and durability of its competitive position that they’re able to arrive at a fully informed view with which to filter prospective investments, select new investment opportunities, manage a portfolio, and thereby attain superior investment returns.