Wide-Moat vs. Deep-Moat Stocks

How wide is your company's moat? And what's its depth?

Unless you're a Morningstar Premium Member--and maybe even if you are--these questions can sound a tad bizarre. Because most of us didn't walk the earth in medieval times--except perhaps for Shirley MacLaine--it's doubtful that you've regularly encountered a real-life moat. And in a country run by elected officials virtually since its founding, it's probably even more irregular to stumble onto a castle.

Thus, it might seem easy to shrug off these questions, lumping them in with the kitschy business inquiries of this age, such as "What color is your parachute?" or "Who moved my cheese?" But this would miss an important point, perhaps the most important in all of investing. Namely, without a moat, there's no reason to expect that a firm you have invested in will generate attractive returns on capital for more than a fleeting period of time.

A more subtle point, but one that is just as important, is that the width of a firm's moat--how broad and numerous its competitive advantages are--matters more than the moat's depth, or how impressive any individual advantage is. Discerning between width and depth can be difficult, however.

First, it's absolutely critical to understand what an "economic moat" is. To read between the lines of comments from Warren Buffett--who spoke of moats long before Morningstar ever started rating stocks--there are two basic components: 1) one or more competitive advantages, and 2) an attractive business at the middle of that moat that earns above-average returns on capital.

In the Oracle's exact words, "In business, I look for economic castles protected by unbreachable 'moats.'" Many investors easily surmise the first point about moats--that a competitive advantage is required--but they miss the importance of the second, which is above-average returns. If the business doesn't throw off attractive returns (making the castle a worthwhile target for competitors), then who cares if the it has a competitive advantage? Autos and airlines are two businesses with very high barriers to entry, but few new competitors are trying to crash the party in a race for single-digit ROEs or bankruptcy.

Over the years, Buffett has frequently referred to his desire to widen the moats of his companies, but it's rarer to see him refer to a moat's depth. In his 1995 letter to shareholders, he notes his pleasure in the widening of auto insurance subsidiary Geico's moat, thanks to rock-bottom operating costs falling further and improved underwriting. A year later, in his 1996 letter to shareholders, he notes that "The economies of scale we enjoy should allow us to maintain or even widen the protective moat surrounding our economic castle." In a 2001 memo to employees, he writes, "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."

Buffett's frequent talk of moat width--and silence on moat depth--speaks volumes. As Harvard competition expert Michael E. Porter has said, "Positions built on systems of activities are far more sustainable than those built on individual activities."

Unfortunately, it can be difficult to discern whether a company has a moat or competitive advantage at all, much less whether that moat is of the wide or deep variety. After all, if a firm has a competitive advantage, it seldom behooves it--or boosts its results--to tell you how the moat has been built. After all, you just might emulate it.

Still, it can be worth investors' time to ponder whether the stocks they're invested in have one really fantastic competitive advantage--that, while deep, may lack width--or if they're invested in firms with a series of advantages that can sustain above-average returns on capital over the long haul.

Consider well-run giant conglomerates like  General Electric (GE),  Citigroup (C), and  Procter & Gamble (PG). Finance theory tells us that these decades-old firms should have seen their returns on capital dribble down to their cost of capital ages ago due to rivals competing away the excess returns. Yet, even the lowest ROE business among these three--Citigroup--still posts upper-teens ROEs in a bad year.

Why haven't competitors captured these profits? Because these businesses are pretty good at an awful lot of things. If Citigroup is hobbled by problems in its private banking unit or regulatory scandals on its trading desks, it can rely on its impressive credit-card operations and retail banking business to carry the day. At GE, if new competition from cable hurts the NBC network or its insurance division posts lackluster returns, it can rely on a cadre of numerous other good businesses to pick up the slack.

Thus, assuming the competitive advantage is of sufficient depth, it can be more productive to widen the moat than to deepen it. To purposefully strain the analogy, it doesn't really matter if the moat is 10 feet deep or 100. Knights aren't going to capture the castle by shoveling dirt into the moat and walking over the refilled trench; they're going to use a ladder or a drawbridge.