Economic Moats Explained: What They Are & Why They Matter - Part IV
Moat depth measures how well a company can defend itself when a competitor decides to attack
For the fourth part of this series, we’ll explore moat depth.
I encourage you to read Parts I-III before reading this post.
Part I: Why Care About Moats?
Part II: Moat Sources
Part III: Moat Width
Part IV: Moat Depth (today’s post)
Part V: Moat Trend
Part VI: How Management Impacts the Moat
In Part III of this series on economic moats, we discussed how moat width serves as a deterrent to competition. The adequacy of a company’s moat width depends on the size of the castle it’s meant to defend.
A nice little business can do quite well with a narrow moat, for instance, but a fast-growing, high-return on invested capital (ROIC) business that everyone wants a piece of needs a wide moat to keep envious competitors at bay.
That said, the economy and companies are complex adaptive systems. Companies do not operate in static environments. Over the course of a decade, even a wide moat business will face at least one serious challenge as consumer tastes change, new technologies emerge, and the availability of cheap capital ebbs and flows.
A company’s ability to withstand such changes - and have the chance to get stronger on the other side - depends on its moat depth. Moat depth is about sustaining product and service relevance over time – no small feat! – and the power to fend off competition that’s trying to siphon off some of its profitability.
Failed moat attacks
The most recent company profiled here at Flyover Stocks, Simpson Manufacturing, contains a good example of the difference between moat width and moat depth.
In 2012, Lowe’s pulled Simpson’s dominant Simpson Strong-Tie brand of structural connectors off its shelves and promoted its own private-label brand.
At face value, it made sense for Lowe’s to try the strategy. The reasoning might have went something like this: Simpson enjoys 40%-plus gross margins on its products – a considerable markup for what appears to be simple metal connectors - and professional contractors regularly need connectors to build sturdy structures like houses and decks. Lowe’s could offer a lower markup through private label, which would delight Pro customers and drive more Pro traffic to its stores.
In practice, however, it was a poor decision. Contractors went to Lowe’s for Simpson Strong-Tie and didn’t buy Simpson Strong-Tie because Lowe’s carried it. Because Simpson is often specified by name by architects and engineers in building plans, if contractors choose an alternative brand, the liability rests with them if the structure fails.
When contractors couldn’t find Simpson Strong-Tie at Lowe’s, they went somewhere else. By 2020, Lowe’s restocked Simpson Strong-Tie to win back more Pro business. In fact, Lowe’s named Simpson one of its vendors of the year in 2023.
A failed moat attack, like the Lowe’s-Simpson example, is usually a good sign that a company’s moat is deeper than it appears. Companies with deep moats often provide their customers with some solution beyond the obvious utility of their products. In the case of Simpson, its reputation for quality and rigorous testing provides architects, engineers, and contractors with peace of mind that structures built with Simpson connectors will hold.
New wine in old wineskins
Another example is found in the streaming wars where the traditional media companies took on Netflix. A few years ago, there was reasonable and genuine concern that when the likes of Disney, NBC, and Paramount took their IP off the Netflix platform, it was game over for Netflix.
That has not proven to be the case.
To Netflix’s credit, it launched original programming in 2013 - well in advance of the threat of big media pulling their content from the platform. By the time Disney+ launched in late 2019, for instance, Netflix had a number of popular original series like Orange is the New Black and Stranger Things.
Despite traditional media companies having the cash, content, and intention to take on Netflix, they have yet to catch up with its technology lead. Here’s Disney CEO Bob Iger in March of this year:
What we didn't have was the technology that we needed to basically lower customer acquisition and retention costs to increase engagement to essentially grow our margins by reducing marketing expenses. We're now in the process of creating all and developing all of that technology. And obviously, the gold standard there is Netflix, we need to be at their level in terms of technology capability.
And one of the reasons why their margins are so much more significant than ours is because they have that technology. So our marketing expenses are significantly higher, our churn rates are higher than they need to be.
Traditional media companies underestimated Netflix’s moat, which from the outside appeared to be built around licensing their IP. Just pull the IP, the thinking went, and Netflix will crumble. They found out there was more to the story once they attacked Netflix’s moat.
Behind the scenes
One thing Simpson and Netflix had in common was nimble and thoughtful management and distinct and robust corporate cultures. (We’ll discuss the role of management and moats in greater detail in Part VI.)
These attributes are critical when considering moat depth and durability. Moats first erode behind the castle walls due to cultural rigidity, myopia, bad capital allocation, and inertia (“This is how we’ve always done it.”) Only then is the company vulnerable to an attack.
Pivoting thousands of employees toward a new strategy is not easy, especially when many of them may have been hired to do a job related to the old strategy. It requires cultural dexterity and buy-in from employees. Indeed, Netflix pivoted multiple times, shifting from DVD-by-mail, to digital streaming, and to original programming.
Recognizability vs. Relevance
The desired outcome of moat depth is to at least maintain product or service relevance over a decade and beyond. It is relevance that commands pricing power and pricing power begets superior economics.
"The single-most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you've got a terrible business. I've been in both, and I know the difference."
- Warren Buffett
There’s a critical difference between relevance and recognizability. A company’s brand might be recognizable but not relevant, in which case the brand cannot command pricing power.
To illustrate, consider the Hanna-Barbera universe of cartoon characters like The Flintstones, Yogi Bear, and Scooby-Doo. Those of a certain age will recall how popular and relevant those franchises were in the 1980s and earlier. When I was a kid, my local amusement park featured Hanna-Barbera characters and many Saturday mornings were spent watching their cartoons.
While the Hanna-Barbera franchises remain recognizable, due to a variety of factors, few of them remain relevant to today’s audiences.
Meanwhile, millions of children remain delighted to see the likes of Mickey, Cinderella, and Belle when they visit Disney theme parks each year - and parents fork over small fortunes for the opportunity.
Both Hanna-Barbera and Disney characters are recognizable, but only Disney characters remain relevant.
Evaluating moat depth
As you’re evaluating a company’s moat depth, consider the following questions:
Has the company’s moat been threatened before? If so, what was the outcome?
If the company disappeared tomorrow, why would their customers be in mourning?
In what ways is the company culturally and operationally agile enough to respond to unexpected changes and threats?
How much more could the company charge for its products before customers would balk at the prices?
What is the competitive intensity in the industry? Does management have time to deepen its moat or is it preoccupied with fighting off new challengers?
These aren’t easy questions to find answers to, but the best questions always take time to research, otherwise everyone would ask them.
Moat width and depth are often lumped into the same category, but I find it helpful to split them into separate analyses as they serve separate purposes. Moat width is concerned with how the economic moat sources deter competition and moat depth focuses on what resources a company has when an attack actually occurs.
In Part V of the series, we’ll explore moat trend, which considers if the company’s competitive position is getting stronger or weaker in the next few years and how that can be a primary determinant of medium-term stock performance.
Thank you for your continued interest in this series and in Flyover Stocks. Please feel free to add your questions and comments below or contact me directly.
Stay patient, stay focused.
Todd
Todd Wenning is the founder of KNA Capital Management, LLC, an Ohio-registered investment advisor that manages a concentrated equity strategy and provides other investment-related services.
At the time of publication, Todd, his immediate family, and/or KNA Capital Management, LLC did not own shares of any company mentioned.
Please see important disclaimers.
So a wide moat serves to deter potential attackers. But if an attack occurs, they might find shallow waters. Their attack might succeed. If however the moat is truly deep, they won't. The competitive advantage period will determine how the moat can last. Thanks for breaking this all down!