Evaluating MOAT's

When evaluating a company's moat, or durable competitive advantage, not much has been written on how to evaluate this in companies. It is probably the most important part of valuing a company and the most misunderstood by analysts. 

The concepts of Scale Economics Shared, Strategic Capital Allocation and the robustness ratio are critical to understanding how companies can create and maintain competitive advantages. These concepts help explain how certain companies manage to grow sustainably and profitably while creating value for both customers and shareholders. 

Most of what is written in this essay has been taken from the Nomad Investment Partnership letters. 

Scale Economics Shared

Scale Economics Shared refers to the benefits a company derives from scaling its operations and how these benefits are distributed among its stakeholders. The core idea is that as a company grows, it achieves economies of scale, which reduce costs per unit of output. These cost savings can then be shared with customers through lower prices, improving the value proposition and fostering customer loyalty, this is highly unusual and the antithesis of what is taught in business schools. This strategy is distinct because it focuses on using scale to enhance customer value rather than merely improving margins. Companies that adopt this model often forgo short-term profitability in favour of long-term growth and customer loyalty.

An exemplary model of Scale Economics Shared is Costco. Costco's business strategy revolves around leveraging its large-scale operations to secure products at lower costs and then passing these savings onto customers. This approach is not merely about achieving low prices but about creating a virtuous cycle where lower prices drive higher volumes, further enhancing economies of scale. This cycle contributes significantly to Costco's competitive moat, making it difficult for competitors to match its value proposition without similar scale and efficiency.

Amazon is another prime example of this strategy. Founder Jeff Bezos has consistently emphasised the importance of returning efficiency improvements and scale economies to customers through lower prices and better services. Initiatives like Amazon Prime and Free Super Saver Shipping illustrate this approach. By continually improving customer value, Amazon reinforces its competitive moat, ensuring long-term sustainability and growth despite short-term financial trade-offs. 

The “Scale Economics Shared” model is contrasted with average companies that may not share scale benefits effectively. Instead of reinvesting in customer satisfaction or operational efficiencies, such companies might see diminishing returns as they grow due to increased complexities and inefficiencies. This distinction helps investors identify businesses that are likely to sustain their competitive advantages over the long term.

Capital Allocation by CEOs

The capital allocation decisions made by CEOs are crucial for the long-term success of a company. Effective capital allocation involves investing in projects that yield the highest returns relative to their risk, whether these are internal projects, acquisitions, share buybacks, or dividends. CEOs must balance immediate financial performance with investments in future growth. Jeff Bezos is an expert at this, and has articulated his views on capital allocation.

CEOs who excel at capital allocation often share a few key traits: a deep understanding of their business, a long-term perspective, and a disciplined approach to investing capital. For instance, Warren Buffett’s management of Berkshire Hathaway illustrates the profound impact of astute capital allocation. By consistently investing in businesses with durable competitive advantages and strong management teams, Buffett has compounded shareholder value over decades.

Warren Buffett’s comments on GEICO highlight effective capital allocation. By dividing cost savings between customers, employees, and shareholders, GEICO ensures sustainable growth while maintaining high customer satisfaction and employee engagement. This balanced approach to capital allocation is essential for creating a robust business model that can withstand competitive pressures and economic fluctuations.

A previous article I wrote,

further explains the concept of capital allocation.

The Robustness Ratio

The robustness ratio is a framework used to measure the strength of a company’s competitive moat. It is defined as the amount of money saved by customers compared to the profits earned by shareholders. This ratio helps assess how well a company can protect its market position and maintain profitability despite competitive pressures.

For example, Costco’s robustness ratio is exceptionally high. The company saves its customers approximately five dollars for every dollar it earns in profits. This high ratio signifies a formidable competitive moat because it becomes incredibly challenging for competitors to match Costco’s value proposition without compromising their profitability. In essence, the higher the robustness ratio, the more difficult it is for other companies to compete effectively on a like-for-like basis.

This ratio also highlights the balance or tension between customer and shareholder rewards. While a higher robustness ratio may suggest that customers are receiving substantial value, it also implies that shareholders might be receiving a smaller slice of the economic pie. The challenge for management is to maintain a balance where the company remains attractive to both customers and investors. Companies with a higher robustness ratio typically enjoy a stronger moat, as they provide significant value to customers, which can lead to increased loyalty and market share.

Integrating the Concepts

These concepts are interconnected and collectively contribute to a company's sustainable competitive advantage. Companies like Costco and Amazon illustrate how Scale Economics Shared and strategic capital allocation can create robust business models. By focusing on delivering superior customer value through efficient use of scale, these companies build strong competitive moats that are difficult for rivals to penetrate.

Effective capital allocation by CEOs ensures that resources are deployed in ways that support these strategies, balancing short-term financial performance with long-term growth and sustainability. The robustness ratio provides a quantifiable measure of how well a company is executing these strategies, offering insights into the strength and durability of its competitive advantage.

By examining these factors, investors can discern which companies are likely to thrive in the long term. Companies that excel in sharing scale benefits, managed by CEOs who allocate capital effectively, and boast a high robustness ratio are typically well-positioned to maintain and grow their competitive advantage. These businesses are often characterised by predictable and sustainable growth, lower risk, and a resilient market position.

Understanding and applying the principles of Scale Economics Shared, effective capital allocation, and the robustness ratio are essential for building and maintaining a sustainable competitive advantage. Companies that master these concepts can achieve long-term success by creating significant value for both customers and shareholders, thus securing their position in the market against competitive threats.

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