A Few Notes on Moats

I’ve had two conversations over the past year about moats that I thought were interesting. Both were from serious operators. Both operators had been whipping their respective organisations into lean, mean execution machines. Both were starting to beat their competitors — the long-awaited fruit of many moons of hard work.

Both were sceptical of moats.

I can understand why. Their journeys have been difficult. One of them is running a company numbering in the thousands of employees. The other had to overcome regulatory (read: political) challenges whilst building their business. When you’ve been grinding on what seems like an endless supply of challenges in the pursuit of excellence, it is difficult to imagine that a competitor can do what is so difficult for you in order to catch up.

But moats matter. I’ve been systematically collecting case instantiations of moats for half a decade now. Here are some things I’ve noticed.

The Theory

The theory for moats is simple to articulate. Longtime Commoncog readers would know that I call this the ‘central problem of business’, because it is. A more formal name that some folks use is ‘competitive arbitrage’: ‘competitive’ because this a problem of competition; ‘arbitrage’ because the net effect of arbitrage is to drive prices towards equilibrium, reducing margins in the process.

Competitive arbitrage works like this: you find something that works and you make a lot of money. For a while, all is good. Then other people notice that you’re making lots of money and they copy what you’re doing, except they offer it for a cheaper price. Then other people notice that those folks are making money and copy them, and offer the same thing for an even cheaper price. This continues ad infinitum until everybody is making very little money and you’re all suffering together.

A moat is a thing that prevents this universal phenomenon from occurring.

I call this the central problem of business because a) the copycat phenomenon happens everywhere, in nearly every industry and in every country, and in just about every time period. Also b) if you are in business you want to make lots of money and not live a shitty life. Having no moat guarantees that your life will become shitty.

Well, that’s the theory, at least. In practice you need to go hunt for real world examples so you’re properly calibrated on what it looks like in practice.

Let’s walk through some interesting observations.

Moats Are For When You (Inevitably) Get Distracted

If a currently operating businessperson is not a huge fan of moats, the odds are good that they are in one of two situations. The first is that they’re looking for product market fit, and the question of a moat is academic to them. The second is that they’re seeing results from superior execution, which takes up all of their time and focus. In both cases moats are not salient, and for good reason.

(This does not include businesspeople who are semi-retired due to an exit and who are sceptical of moats — we’ll talk about those folks in a bit).

I want to emphasise that scepticism of moats are mostly reasonable. After all, which is the bigger problem: cleaning up the underperformers who have slowly gunked up the core of your management and are causing you huge pain today, or worrying about moats? Of course the former.

But there is a way to make moats appear more salient. My go to example is this: let’s say that something horrible happens tomorrow. Your parents fall sick. A child dies. Or you go through a messy divorce. Bad things can happen to good people over the long arc of a life. And so you might go through a trying period in your life, only to come out the other side to find out that your execution advantage, so dearly won, has been eroded in the years that you let your eye off the ball. So now you’re emotionally scarred and you have to fight against formidable competitors who have caught up; you are left competing on an even playing field.

That sucks! The reason to have a moat is so that you can have a buffer in case you need to take your eye off the ball for a bit.

Conditions for Competitive Arbitrage

There is actually a huge caveat to the necessity of moats.

I talked about competitive arbitrage like it is a universal thing. This is by-and-large correct. In truth, however, margin compression only occurs in situations where a couple of underlying conditions are met. These conditions are all so common you might be tempted to say that they occur in every market and with every business opportunity known to man. These conditions are things like:

• Other people can learn that you’re making a lot of money.
• Other people are willing and able to copy you.
• Your competitors are competent enough to give you trouble.
• The market you’re in isn’t growing rapidly (or is unable to support the set of competitors that are currently present).
• You want to be in business for a long time, perhaps because you want to build an empire (or you want to become a tycoon).

If these conditions are all present, you can betcha that competitive arbitrage will happen to you. In fact, we maintain a concept sequence called ‘Competitive Arbitrage’ in the Commoncog Case Library, filled with cases of businesses and businesspeople who have suffered from excessive competition. But here’s a funny thing: if any of these assumptions do not exist, then competitive arbitrage might not show up for a long time. Which means you can do very well without a moat!

With these conditions as a guide, we may seek out scenarios that are exceptions. Let’s take a look at some of them right now.