Island Investing
Cale Smith, MBA
August 5, 2009
Keys Weekly

Q. What is a “moat”?

A. Some businesses are better than others. That simple truth can be hard to remember, especially if you’re rushing to invest in the market out of fear that you’ll miss the latest rally. Keep in mind that what makes a business great doesn’t change from day to day or even year to year. You’ve got plenty of time to slow down and think about moats.

An economic moat is a structural competitive advantage that prevails for a long period of time and is very difficult for a competitor to copy. A moat is important because it ensures a business will be excessively profitable for a long period of time. The longer the period a company will be profitable for, the more that company is worth today. Companies without moats can also see their financial results change for the worse, sometimes suddenly and dramatically.

Wal-Mart is a great example of a business with a wide moat. Because the company controls so much shelf space, it can demand the lowest possible prices from its suppliers. Its sheer size means it gets better terms on store leases and distribution agreements than competitors, too. Wal-Mart is the low-cost leader in the retail industry because it has a structural advantage that would take competitors decades and billions of dollars to match.

Intangible assets can create a moat, too, like the Coca-Cola brand. Businesses whose customers find it too troublesome to move to a competitor have what is called high switching costs. Banks have historically been good investments – the last 18 months notwithstanding – because people are so reluctant to switch.

Businesses like eBay that possess “network effects” also have a wide moat. The buyers come to eBay because that’s where the most sellers are, and vice versa. As a result, eBay receives over 80% of all online auction traffic in the U.S. and potential competitors are unable to lure buyers or sellers away.

To learn more about moats, I’d recommend The Little Book That Builds Wealth by Pat Dorsey. Excellent book, horrible name. It’s a great primer on recognizing competitive advantages.

Cale Smith is the portfolio manager for the Tarpon Folio and Gecko Folio. His firm’s website is www.islainvest.com and his blog is www.caleinthekeys.com.