Main Street Moats

"Here we must run as fast as we can, just to stay in place. And if you wish to go anywhere you must run twice as fast as that.” — Through the Looking Glass by Lewis Caroll

We think companies must evolve faster than the outside world or face irrelevance, decline, and eventual extinction. Between AI, tariffs, and the broader macro environment, the rate of change is increasing and this creates new challenges for leaders. Purely winning through execution is tough – it is exhausting, never gets easier, and the rewards of success are limited. Moats or competitive advantage offer a way to counter this challenging environment. This is a topic we frequently discuss with business owners and below we share a few observations and thoughts on the topic.

First, a moat represents a competitive advantage that protects a business from competition. Moats are a function of the business and industry structure, and they allow a company to avoid being commoditized in an economic sense. A good business should generate above average returns and be able to sustain this in the fierce competition of capitalism. We find Pat Dorsey’s framework for classifying moats into four buckets insightful:

• Cost advantages

• Intangible assets

• Switching costs

• Network effects

Each bucket often has different sub-moats – for example intangible assets include intellectual property and brands, and cost advantages could be driven by scale or access to unique resources. Moats are not born. They are built. On Day 1 a company inherently has no competitive advantage, but over time they can become a formidable barrier. If we invert, it is also helpful to define what a moat is not – it is not just a great product or great management but a structural advantage. And not every company has a moat.

The moat should be more than just identifiable – it should lead to above average economics over time. We like to measure this based on earnings before interest and taxes (EBIT) divided by net working capital plus net fixed assets in the business. In this case, higher is better because you are earning more profit for each dollar invested in the company. Michael Mauboussin has some great pieces on this topic including “Measuring the Moat” if you are interested in learning more.

Most of the literature on moats and strategy focuses on large Fortune 500 companies. Yet, the same concepts and ideas apply to midsize companies. Correct market definition is fundamental to strategy, and we find midsize companies with moats often participate in one of two markets types:

• Local markets – e.g., businesses like home services or rock quarriers are inherently local

• Niche markets – e.g., the market for golf course software

Once the market is properly defined, we think Dorsey’s framework works well for midsize companies. For example, a plumbing business can build a strong local brand and also have more scale than its local competitors. This in turn enables it to have a more efficient marketing engine, better technology and support capabilities, and higher profitability, which can in turn be invested to drive more growth. Another example is vertical market software where the product has switching costs and serves a relatively small total market. This makes it hard for a new entrant to enter and compete because the cost to do so isn’t worth the size of the prize.

In assessing moats, we generally think about three components: strength, durability, and runway. These dimensions impact the long-term cash flows and thus value of a business. Strength is how wide or strong the moat is today. For example, we think a company like Visa has a wide moat today. Even with a billion dollars, it would be nearly impossible to displace Visa without a major tech or regulatory shift. The second component is durability, which is how long the moat is likely to persist. Wrigley chewing gum is likely to have a more durable moat than a technology product given the rapid pace of change in the technology sector. Third, runway reflects the opportunity to reinvest while continuing to earn high returns from the moat. Chipotle’s growth from 16 stores in 1998 to 500 stores in 2005 is a good example of reinvestment runway (it also happens to be one of our favorite places to eat at Kanbrick). Often, niche markets have strong, durable moats but limited runway because once you get outside your core market someone else has a competitive advantage. The best moat is strong, enduring, and has lots of potential for reinvestment – a rare and very valuable bird.

Just like rivers, moats are not static. They are constantly widened or narrowed. This change occurs based on multiple factors including strategic choices, competitor choices, execution quality, regulatory changes, and technological innovation. Technological innovation can be particularly impactful and historically has occurred in 20 to 30 year cycles. The evolution of AI appears to be the next paradigm shift – following things like the railroad, electrification, and the internet – that will rewrite the rules of the game. We are focused on this across our companies and think it is an important strategic challenge; although, some businesses will undoubtedly be more significantly impacted.

Moats define how do we beat our competitors or at least keep them at bay. However, customers buy the value you provide not what protects your business from competitors. Thus, the best companies connect their moat with their customer value proposition. This defines why customers choose a given business. Customers don’t directly care about your cost advantages or intellectual property. Instead, they have a job to be done and a set of key decision criteria.

In our view, the best value proposition connects the customer value to the moat or strategic advantage. For example, Costco’s moat is its cost advantage (e.g., scale in purchasing, low-cost stores, membership model, and working capital model) and brand (intangible asset). These drive its consumer value proposition flywheel of offering exceptional prices on a curated selection of high-quality products which in turn attracts more customers and drives more volume leading to lower prices. Competitors aren’t able to match these aspects, so Costco is able to both offer a superior customer value proposition and also maintain its strategic advantage.

Moats and strategy are hard. This is an area we focus on deeply with our companies and across the Kanbrick Community. If you want to learn more, please check out our strategy content. We also are always glad to connect to talk more about your business and its strategy.