Lesson 2 of 8
A barrier is not an advantage
Doing something better is copyable. The 1991 Berkshire letter gives three conditions for the kind that is not, and one result that demonstrates all three.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- An advantage is something you do better; a barrier is something a competitor cannot do at all. Only the second survives being noticed.
- The 1991 Berkshire letter gives three conditions for an economic franchise, and says their presence is demonstrated by the ability to price aggressively and still earn high returns on capital.
- Mauboussin, Callahan and Majd require two things of a competitive advantage: returns above the cost of capital, and an economic return above the average of competitors.
Being good at something is not a moat. It is a head start, and a head start in a market anyone can enter is competed away by the people who noticed it.
Two things that both look like advantages
An advantage: doing it better
- Lower cost through better process, or a better product.
- Visible to competitors from the outside, in prices and margins.
- Copyable by anyone willing to spend what you spent.
- Erodes as the method spreads, which it does.
A barrier: they cannot do it at all
- Customers will not switch, or a licence or contract blocks entry.
- Scale inside a market a competitor would have to take from you.
- Copying requires the competitor to win customers you already hold.
- Persists while the condition that creates it persists.
Both raise returns. Only one of them stays raised after a competent competitor decides to attack it.
The three conditions
The 1991 Berkshire letter defines an economic franchise as arising from a product or service that is needed or desired, that is thought by its customers to have no close substitute, and that is not subject to price regulation.
The letter is careful about how you would know. The presence of all three is demonstrated by an observable result: the company can price its product or service aggressively and thereby earn high rates of return on capital. The letter adds that a franchise tolerates poor management, which can reduce its profitability but not inflict mortal damage, while an ordinary business can be killed by it.
The contrast it draws is exact. A business, as distinct from a franchise, earns exceptional profits only if it is the low-cost operator or while supply of its product is tight, and tightness in supply usually does not last long.
The two-part test
Mauboussin, Callahan and Majd ask for two things before calling something a competitive advantage. The company must generate, or be able to generate, returns in excess of the cost of capital. And it must earn an economic return higher than the average of its competitors.
The two are not the same and both are needed. A company earning above its cost of capital in an industry where everyone does is riding a structural condition that will attract entry. A company earning more than its competitors while all of them destroy value is best of a bad set.
Why this distinction decides a thesis
A thesis resting on an advantage needs a guardrail on the thing that erodes. Margin, or share, or the price premium. When the advantage is copied, that figure moves, and moves early.
A thesis resting on a barrier needs a guardrail on the barrier itself: the retention rate, the licence, the contract renewal. Those move late and rarely, and a guardrail on margin would have told you nothing until the year the barrier had already gone.
Check yourself
Which three conditions does the 1991 Berkshire letter give for an economic franchise?
- High margin, low capital intensity, a famous brand
- The product is needed or desired, is thought by customers to have no close substitute, and is not subject to price regulation
- Patent protection, scale, and regulatory capture
Show the answer
Answer: B.
The letter also says how their presence is demonstrated: by the ability to price aggressively and thereby earn high rates of return on capital.What two things do Mauboussin, Callahan and Majd require before calling something a competitive advantage?
- A high market share and a rising margin
- Returns in excess of the cost of capital, and an economic return higher than the average of competitors
- Patents and switching costs
Show the answer
Answer: B.
Either alone is insufficient: beating a cost of capital everyone beats attracts entry, and beating competitors who all destroy value is not an advantage worth having.A thesis rests on a barrier rather than an advantage. Which figure should the guardrail watch?
- Operating margin, because it erodes first
- The barrier itself, such as the retention rate or the contract renewal, because margin will not move until the barrier has already gone
- Revenue growth
Show the answer
Answer: B.
An advantage erodes through the income statement. A barrier holds the income statement steady until it fails, so watching margin gives no warning.Sources
- Berkshire Hathaway shareholder letter, 1991: the three conditions of an economic franchise, the observable result that demonstrates them, and the contrast with a business that earns exceptional profits only as the low-cost operator or while supply is tight.
- Mauboussin, Callahan and Majd, Measuring the Moat, Credit Suisse, 1 November 2016: the two characteristics a company must have to claim a competitive advantage.
What this leaves out
- The three conditions are a description, not a screen. No filing reports whether customers believe a close substitute exists, so the test has to be run on evidence outside the statements.
- The worked example uses invented round numbers and is labelled illustrative.
- Nothing here is advice about any security.