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Few can explain the importance of an “economic moat” better than Warren Buffett, who said: “Capitalism is all about somebody coming and trying to take the castle … A good business is like a strong castle with a deep moat around it. I want sharks in the moat. I want it untouchable.”

At the same time, the Oracle of Omaha acknowledged the difficulty of gauging how big or resilient a moat is. “No formula in finance tells you that the moat is 28 feet wide and 16 feet deep. That’s what drives the academics crazy,” he said.

To be clear, when one uses the term “moat(s),” they really mean durable “competitive advantage(s).” Durable competitive advantages allow companies to earn returns exceeding the cost of capital, thereby creating shareholder value. And that means positive returns for investors.

One good example of a moat would be the one enjoyed by Microsoft Corp., which has an advantage over its rivals by virtue of the fact its Windows Operating System (OS) has a nearly 75-per-cent share of the desktop OS market. While financial switching costs are low, the time it would take most to learn a new OS is significant and thus the product enjoys considerable “stickiness” benefits.

But investing is not only a science but also an art, which means it’s not possible to make precise estimations about how protective a moat is. When it comes to finding a truly durable moat, look for the obvious signs to start with. A few examples are 1) consistent market dominance; 2) consistent market-share gains; and 3) consistent superiority in business financials (e.g., profitability, return on capital, per-employee revenue, maintenance capital intensity).

As you may have noticed, the key word here is “consistent.” We look back over multiple years (sometimes, more than a decade or two) when researching an interesting business. Luck is unlikely to keep a business winning over its competitors – both current and potential – over the long term.

How many signs do we prefer to see? The more, the merrier (think margin of safety). For example, Evolution Gaming Group has been the market dominator in the live casino sector in Europe and the United States. The company has a track record of high-performing financial results for at least a decade, since it became public. It has also increased its competitive gap almost every year since the initial public offering.

Since its 2015 initial public offering, revenues have enjoyed a 50-per-cent compounded average growth rate (CAGR) while global online live casino CAGR and global land-based casino CAGR have grown in the mid-double-digits and low-single-digits, respectively.

Looking backward tells us a lot about the past but not necessarily much about the future (although we do find that winners generally continue to win). For example, the Buffalo Evening News was a well-moated business until the internet came along, and the competitive advantage quickly shifted from newspapers to the likes of Meta or Google.

Similarly, Kodak’s competitive advantage disappeared quickly when digital cameras emerged. Blockbuster got eaten by Netflix. The point being that it is to one’s benefit to not only assess the presence of a moat, but also to give serious thought and consideration to its durability and width. Jeff Bezos once quipped: “I almost never get the question: What’s not going to change in the next 10 years?”

Technology, for example, is a fast-moving and competitive space. The industry is built on disruption where yesterday’s darlings (Myspace, Polaroid, Netscape) are quickly forgotten. Alternatively, we can be fairly certain that we will still be eating and drinking for decades to come. Confectionary, food and beverage brands can endure for decades and even centuries.

Fevertree Drinks PLC is a beverage maker that has only been around about 20 years, but it dominates its space (premium mixer) and demonstrates consistent market share gains. Although it doesn’t have the consistent margins and returns on capital that we like to see, it could be considered a narrow moat company because it has gained a first-mover advantage by producing a particularly wide range of mixers and has leveraged third-party marketing through the use of influencers and thought leaders in the industry.

Lastly, it’s worth mentioning that it’s not difficult for one (even a professional) to talk oneself into believing a moat exists – hence, the importance of hard evidence. Traditional textbooks and business schools would often point to various sources such as brand, scale, intellectual property, and network effect – the principle that the more widely a product is used, the more its value increases.

In our view, categorization may not be that simple in the real world, as assessing whether a company has a moat is not always straightforward. In addition to the “consistent” factors we looked at earlier, factors such as customer, supplier, competitor, regulator and corporate culture can also come into play.

Jason Del Vicario, CFA, is portfolio manager at HillsideWealth | iA Private Wealth Inc. Steven Chen, MBA, is global analytics associate at the firm.

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