The monumental concrete glory, known as the “Maginot Line”, included 142 large artillery forts, 352 fortified gun emplacements and 5,000 smaller bunkers (or pillboxes). Behind the imposing line of fixed defensive positions, tank traps and high concrete walls were fully equipped subterranean bases complete with mess halls, hospitals, recreation facilities and railway lines.
The Maginot Line was thought to be impenetrable and would prevent any WW1-style infantry and artillery attack. At the beginning of World War II, however, it wasn’t able to stop the Nazi war machine from quickly overwhelming and occupying France. The Germans quickly abandoned older tactics for a far more mobile and manoeuvrable attack that disrupted and dismantled the French defensive strategy.
The Oracle of Omaha: Warren Buffett
It’s not hard to see how a huge defensive wall around a business to protect it from competitors might create a very attractive investment. But by focusing only on the size of the moat, investors can miss the opportunity to invest in smaller businesses disrupting the status quo: either globally, like Amazon (AMZN.NASDAQ) or Google (GOOG.NASDAQ), or locally, like REA Group (REA.ASX) or Jumbo Interactive (JIN.ASX). Competition is a potent force in capitalist societies, and mature businesses that once had seemingly “impenetrable” moats have been overrun by the forces of ‘creative destruction’ – think Kodak and Blockbuster.
Instead of focusing only on those mature companies with an existing moat, finding companies that are in the process of building their competitive advantage could be a boon to your portfolio. Beyond the clear-cut growth indicators like compounding revenue and increasing market share, here are some other barometers of an emerging moat:
Management reinvest capital into the business effectively
“Friends congratulate me after a quarterly-earnings announcement and say, ‘Good job, great quarter.’ And I’ll say, ‘Thank you, but that quarter was baked three years ago.’”
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Reinvestment usually comes in various forms, e.g. research and development; capital expenditure to increase capacity, enhance reliability or boost quality of product or service; and marketing to reinforce branding or gain larger mind share amongst customers. What’s important is to find a company that can continually reinvest funds and earn a high rate of return – the longer this runway, the better.
Destination focussed, avoiding the pursuit of short-term goals
To appreciate the long term focus of building this flywheel, consider this story of Costco founder Jim Sinegal, recounted by well-known investor, Nick Sleep in 2002.
When the opportunity arose to take a higher gross margin than usual on a US$2 million shipment of designer jeans from an exporter (i.e. more than the standard 14%), Sinegal firmly insisted on refusing to break the contract with Costco’s customer, arguing with the exporter that if “I let you do it this time, you will do it again”.
Sticking to the long term destination focus of customer loyalty and footprint expansion has resulted in a 10x return on an investment in Costco from 2002 to today. The focus has firmed the brand, the stickiness of its suppliers and customers – an upward trajectory of its moat.
Alternatively, companies that either damage customer loyalty with operational pivots or reduce investment needs in order to boost short term profits are mortgaging their moats, especially if competition is spending heavily to take over its market share.