The Most Important Moat

Posted on Posted in General Thoughts, Investment Philosophy, Investor Letters, Saber Capital Management

I recently wrote an investor note on some thoughts I have on customer value, and why I think it’s important when analyzing businesses. I thought I’d share that letter here:

In the note, I outline why I think that when you’re evaluating the durability of a company’s moat, it’s critically important to consider the value of a company’s product from the customer’s perspective. It’s a concept I’ve been thinking about for the last year or so, and one that I’ve written about a few times, including in Saber Capital’s 2016 letter as well as in a post containing my main takeaways from Buffett’s annual meeting in May.

In the most recent note I sent to investors last month, I discussed a few brief examples of traditional moats that are losing their strength, but my main point is that customer value is one of the most important things to consider when analyzing companies.

The Widening of Amazon’s Moat

Along these lines, I recently read a TechCrunch article that was very interesting. Talking about Amazon’s moat is very en vogue right now, but I’ve always liked studying and reading about that company. The author of this article goes into discussing his views on why Amazon is so dominant, and is unlikely to be caught.

The author argues that Amazon’s moat has widened because of this extreme focus on customer service and satisfaction to the point that it influences their business model. For example, they allowed third parties to sell their own goods on Amazon’s marketplace (Amazon.com), which puts these sellers in direct competition with Amazon’s own inventory. All of this was obviously done with the goal of profiting, but it started with trying to create a platform that would create the most value for the end customer that shops on Amazon.com (more merchants mean more selection and competitive prices).

This worked out extremely well for customers, and what followed was a growing revenue stream for both the third party sellers and of course for Amazon, which clips off a commission each time it connects a buyer with someone else’s inventory.

Following the success of Marketplace, Amazon also gave competitors access to their cloud computing infrastructure, their call centers, their warehouses, and very soon, competitors will be using excess space on Amazon’s trucks and planes.

Basically, Amazon has turned its largest cost centers into sources of revenue. Computing power, warehousing, and shipping are all large expenses for Amazon. But they are also now sources of revenue.

Difficult Model to Replicate

This is not just a brilliant strategy, it’s one that is extremely difficult for competitors to replicate. The author outlines a few reasons why this is the case:

Customer-Focused Culture

Competitors will struggle offering third party services because they lack the customer-oriented culture that Amazon has (and this can’t really be “faked”).

The author discusses how Wal-mart should be primed and positioned to offer its distribution capacity to competitors if it wanted to, with its massive footprint of 11,500 stores, 6,000 trucks, and more warehouse space than Amazon. But they have developed a different DNA since the days of Walton. While they’ve always been tough on suppliers, it’s likely they spend more time thinking about suppliers and competitors than they do customers. And this prevents them from maximizing their infrastructure.

For example, Wal-Mart recently made news for blacklisting certain vendors that use Amazon’s servers, regardless of whether or not those vendors might have a product that could result in a better, more valuable experience for customers. This is a decision Amazon would never make, because they have a customer-centric (not competitor-centric) DNA.

Experience

It’s also difficult to copy Amazon’s model because others lack experience selling their own excess capacity to competitors (Amazon has been experimenting with handling third party inventory for ten years, making lots of mistakes along the way).

Long-term View

While this is often stated as an advantage, very few companies have the ability to withstand years (and it takes years to perfect these types of businesses) of losses (“investments”) in order to figure out how to run these businesses profitably. Even if they knew that at the end of the road there would be massive profits, the management team isn’t usually incentivized to forego current profits – even if those investments in such businesses will produce huge returns on capital in 5 or 10 years. Also, despite what they say, most investors won’t be able to stomach those interim losses either. So companies don’t typically embark on uncertain capital investments if the payoff is years away, even if these investments will yield huge returns on capital.

Amazon: Its Own Best Customer?

The real genius behind Amazon’s approach is that Amazon is keeping itself lean and mean by marketing their services (Amazon’s expenses) to third parties. This avoids various divisions getting fat, because Amazon now has customers to serve in these areas. Bloated costs and overpriced services won’t sell because some competitor will do it cheaper. So Amazon is forced to stay focused.

Some will argue that this approach was an intentional strategy by Amazon. Ben Thompson wrote a great piece a year ago about how Amazon offers up these services (computing power, warehouse space, logistics, etc…) to third parties because Amazon itself is the number one customer of those very services that it is selling.

Ben makes an interesting argument, and I think he’s correct in analyzing the result of this strategy, but I don’t believe Amazon’s capital investment and third party offerings were done with the intent of Amazon becoming the first and best customer of its own offerings. I think this might have resulted in a massive side benefit for Amazon (keeping Amazon’s cost structure lean and mean), but I think Amazon’s motive was simply to rent out a portion of its unused capacity for profit (why let excess space on the server or in the warehouse go unused when someone else is willing to pay for it?)

It’s a lot like renting out a vacant room in your house on Airbnb. You do it because it makes you a profit on something you own that you’re not using, but in the process it forces you to keep your house neat and clean for your guests.

Buffett Moat vs. Bezos Moat

I’ll wrap up this post by referencing one more article on this topic worth reading. My good friend and fellow investment manager Matt Brice and I share some of our research notes, investment journal posts, and our investment ideas at a members site we started last year. Writing has a way of clarifying your thought process and deepening your understanding of a subject matter. Just like teaching, the person doing the writing is often the one who benefits most from that writing. It was in this spirit that we decided to share some of our thoughts on a separate page. Though we are good capitalists seeking profit, and though we both have a love for teaching, the main reason for the site is to aid our objective of continual self-improvement, which we hope and expect will lead to better results for our investors.

An example of one of these investment journal posts is one that Matt wrote that is related to this topic of moats, and is well worth reading. In the post, Matt describes what he calls “Buffett Moats” vs. “Bezos Moats”. He explains Buffett Moats as companies whose competitive advantage is derived by some structural advantage in the market that is difficult for competitors to attack. Examples of these types of companies in years past might be cable operators, local newspapers, or consumer goods with strong name recognition and abundant shelf space. These are companies that owned some sort of metaphorical toll bridge that its customers had to cross. If you wanted to read the news in Buffalo, you had to go through Buffett (who owned the Buffalo News).

Matt describes the Bezos Moat as a company whose moat stems from its ability to provide value to the customer on a consistent basis. Amazon is obviously the posterchild for this approach, but other industries such as taxi cabs and cable companies have seen their once-dominant market positions encroached by companies that are able to provide more value to the customer.

As he summarizes it:

“A Bezos Moat is premised on the idea that the customer is willingly and is frequently entering into a commercial transaction with the company because the customer is deriving more value from the transaction than he or she is paying for.  

“A Buffett Moat attempts to identify companies that will be the only one (or one of a few) available in a commercial landscape, so that the customer is, in effect, forced to transact with these companies (i.e. only bridge, only newspaper, only soft drink option).”

His post references some examples, and also describes his opinion that Buffett is recognizing this shift in business and is likely to evolve his investment tactics accordingly over time, just as he evolved from cigar butts to quality companies.

To Sum It Up

As I laid out in my letter, finding great long-term investments means locating companies with durable earning power and bright future prospects. Now, more than ever, I think evaluating a competitive advantage needs to start with the value that the company’s customer is receiving. A company that produces significant profits at the expense of its customer will likely see its earning power eroded over time. Conversely, companies that are focused first and foremost on customers (even before competitors) have one of the necessary ingredients to a lasting competitive advantage. A strong customer value proposition certainly doesn’t guarantee a durable moat, but without it, I think it guarantees that any edge will be fleeting.

In summary, a business that can provide value to its owners while simultaneously providing value to its customers is the type of business that I’m looking for, because I think both of those factors are required. Without the latter, the former won’t be possible in the long run.


John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

To read more of John’s writings or to get on Saber Capital’s email distribution list, please visit the Letters and Commentary page on Saber’s website. John can be reached at john@sabercapitalmgt.com. 

 

23 thoughts on “The Most Important Moat

  1. I am a Costco stockholder, and am surprised by their recent skid. Biggest drops coming after news of AMZN acquiring Whole Foods. For me, Costco is a great customer-centric company that provides affordable prices and quality products, happy employees (i.e.., Costco stores tend to receive higher salaries compared to competitors) who provide excellent customer service, and excellent return policy. I also have noticed Costco is now offereing an array of organic goods, and have partnered with supplies to offer quality and affordably priced organic goods. Some have argued, in the long term, Costco will lose out to AMZN, which I disagree. For one, Costco customers are very loyal. Secondly, I feel like the “AMZN customer” will also shop at Costco, or at least place online Costco orders via a delivery app (ex. Instacart). I still see many businesses offices using Costco delivery for in house supplies.

    I feel like their is an opportunity for Costco and agree that they can increase their online orders and deliveries. Walmart did a great job of acquiring Jet.com to increase their competitiveness. I personally like enjoy Jet.com, especially their interface less cluttered than AMZN. If I have an opportunity to speak to Costco, I would encourage them to purchase Instacart, who will most likely get phased out of Whole Foods by AMZN.

    1. I think Costco is a great business as well, but I do think Costco customers are shifting some (not all, but some) of their purchasing to Amazon. At this point, it’s not as much about low prices as it is about convenience. Why make the trip to the store and fight the lines when you can tap on an app or ask Alexa to get you something? It’s such a big factor that is so hard for the brick and mortar stores (even great ones like Costco) to match. But lately it seems that the narrative becomes (will Amazon kill this business or that business?)… there is gray area there. Not every brick and mortar company will turn out like Kmart or JCP. But if Amazon can take even a modest share from Costco, that will cause a fairly significant headwind for earning power. Just something to think about. Costco isn’t going anywhere, but at this point the question would be what is the earning power looking like 5 years or 10 years out, and is the valuation reflecting it?

      1. I’ll be following upcoming Costco as well as other retailers earnings closely. Target news this week gave a bump to ALL retailers.

        Also, keep asking myself how AMZN would fare during a recession or economic downturn? Who knows when and if that will happen, but I will assume they would not be offering a lot of the perks as they currently as they are competing to gain market share from competitors. I remember in the last downturn (banking crisis) Walmart and Costco did amazing.

  2. John,
    As always, this is a great read. Yes, count me as someone who has never owned AMZN and sometimes tortures himself by looking at the 5, 10 and 15 year compounded returns on Morningstar (ugh).
    This Buffett Moat vs. Bezos Moat is an interesting concept to ponder. I admit that upon finishing the post I wondered what your thoughts on AMZN are given it’s current market cap of ~$475 billion. Is it worth that much even if one agrees with all the positives you’ve written about here? I ask this as I recently read a blog post by Smead Capital titled “The General Theory of Reverse Float” which highlighted the effects of stock-based compensation specifically using AMZN as an example (and how many people choose to ignore it).
    Thanks

  3. Good one John..always look forward to your letters/posts.

    You described Amazon’s customer centric approach pretty well, comparison with Buffet model was interesting 🙂

    Uber, Airbnb did just that as well.

    Thanks.

  4. What a fantastic post ! Thanks John for this very thought provoking post which clearly gets readers to explore the concept further.

    1. So a continuation of my objections to this post:

      1, Using Amazon as a customer centric company: There are several examples of Amazon being exactly the opposite – from letting the sale of fake goods grow on is site and being slow to address it, the examples of Amazon acting against user interests in the latest Echo Show and so on. If that is not enough, Amazon is a prolific user of “dark patterns” on its site. Dark patterns are design patterns that are used to trick users into signing up or things that they don’t really intent to. Notice how many times Amazon shows up in this list: https://twitter.com/darkpatterns

      2, A customer also derives value from a Buffet moat company. Even if the company is the only one available to transact with, that customer has the option of non-consumption. So, in this case the customer derives more value from consumption over non-consumption. That is why the transaction happens. BTW, companies like Amazon and Uber are working really hard to build Buffet-type moats i.e. being the only option for customers so that they can control pricing.

      3, Most if not all profits come at the expense of the customer either economically (Eg Apple) or other means (privacy in the case of Google). In fact, customer focused companies have more expensive products and charge customers more. Eg. Armani, Four Seasons, etc .

      4, Cable companies, mobile operators, etc are examples of companies that can be described as customer hostile and have not seen their moats eroded over a long period of time. A few counter examples to your conclusion, there are many others. The converse, as you pointed out, is also not true. So is there any relationship between customer focus and moats?

      In conclusion, your posts confuses a lot of different concepts, many of which don’t have a cause-and-effect relationship.

      1. Thanks for the comment Chris, and good/interesting points. I’d say regarding the telecom companies, I think their moat was uninhibited for decades, but that is now changing. I think technology, the web, the plethora of information have led to much more informed consumers when it comes to brands (no longer need to “trust” Dove soap or Heinz catchup when you can quickly research and determine that some private label or startup product on Instagram is just as good or better). Also, more specifically to cable companies, technology has led to disrupters that have given consumers alternative choices for their time (Netflix and Hulu are obvious examples, but also Facebook and other things that soak up our finite hours). So for a long time, I don’t think my comment about companies facing disruption if they aren’t customer focused would have been true. Cable companies and newspapers were tollroads that had to be crossed if you wanted to consumer that product. So I think distributors in some ways have seen their value as middleman gatekeepers eroded in recent years. But for decades that wasn’t the case. I do believe going forward, if a business is extracting value from customers (if the transaction isn’t a “win-win” then there will likely be another competitor to fill that void because barriers to entry are much lower).

        Anyhow, just some thoughts on your last point about whether there is any relationship between customer focus and moats. I think it is much stronger now than it was in decades past.

        One last thing I’d mention is that having a “Buffett Moat” is not a bad thing. Bezos certainly wants his company to be the toll-road of commerce. I think the key is to determine whether customers that are crossing that toll road are feeling like their getting a good deal as they drive across the bridge. If so, the toll road (i.e. Buffett Moat) is a great and very valuable asset to have. If not, I think it’s potentially a risk.

        Thanks for the thought provoking comment…

        1. There is an underlying assumption here that cable cos are getting disrupted due to their lack of customer focus.

          If you are using the word disruption in the Clayton Christensen sense, the causes of disruption are often the natural technology dynamics i.e. improving performance and focusing on higher value customers. Not customer focus.

          If you are using word disruption in a broader sense – it can have even more possible causes (lack of customer focus being one of them).

          I don’t see evidence that it is lack customer focus (and not, say, technology cycles) causing disruption. Instead, cable cos would likely being facing disruption even if they were customer focused. The reason being that they are invested on older, more expensive technology. The OTT players have none of legacy technology and can be cheaper & more efficient regardless of customer focus.

          As my business school prof used to say, “strategy is about commitment”. Today, Amazon is committing itself to a business & product delivery models. It can choose the most efficient models because it is new. Over time, the commitments grow. In fact, the more they invest, the bigger they grow, the less adaptable they become. When new players emerge with better models, they become more susceptible to disruption. This happens regardless of customer focus or the value you provide to customers because the new players can provide better value in a way you cannot.

  5. Great post! I read other articles on the Amazon bull case before but it was not clear to me, until now. I would like to add that Amazon tries to create network value from every new service it develops and starts selling to external customers. For example, by becoming a big reseller the Amazon websites attract more traffic and becomes more valuable for other sellers. Similar effects play a role with their other services, often they increase the economies of scale to a point that it becomes very difficult to compete for pure players. To a certain extend Amazon.com is like Google, Facebook or even Microsoft, although I suppose these 3 companies have still stronger network value, especially Google.

    Amazon has moat but is it reasonably priced? I think too much of its future growth is already priced in its very high EV/EBIT.

    1. Thanks, I think Amazon’s moat is probably stronger than any other company out there, with the exception of maybe Tencent Holdings (the owner of WeChat). Unfortunately, I don’t own the stock, as I do think a lot of Amazon’s greatness is probably reflected, but from time to time the market goes through a period of pessimism on Amazon (most recently in late 2014 after the FirePhone flop and worries about continual losses). It seems unlikely that that type of pessimism will return given that Amazon hype is probably at an all-time high, but my guess is it will in some form at some point.

  6. Great post John! Do you have any views on Visa/Mastercard where the customers are banks, merchants and consumers but the fees they charge are passed through to banks at the expense of merchants and consumers? How sustainable would that be when the issuing banks are incentivized to issue more Visa/Mastercard cards but the merchants and consumers pay for that?

    1. It’s a great question… I’ve thought some about Visa/Mastercard. Looking at their transaction fees, especially when comparing it to other payments networks around the world (like Alipay or WeChat Pay in China) would make me somewhat nervous if I were a shareholder. They’ve been great businesses, and they have incredibly valuable networks. I probably agree mostly with Munger when he says “if you think you know where the payments industry will be in ten years you’re delusional”. Hard to see a future without Visa and MasterCard dominating payments, at least here in the US, but sometimes when things change they can change quickly. I’m not sure I feel that strongly about it, but there could be some significant bumps along the way.

      1. I think the advantage to Visa/MC (I own both, MC for a few years) is that their profits are invisible to the end user – so the end-user has no real incentive to change. Also, their moat (in my opinion) is almost triple-edged, in the sense that they have agreements with almost every vendor in the US, plus banks who service the cards, plus (effectively) the cardholders themselves. To compete with them, you’d have a big problem on your hands.

        I’m pretty sure Berkshire owns MC, so I’m a bit surprised at Munger’s comments.

        I liked your post, John. I think it can be a little dangerous to just study the successful businesses though, as it can lead to wrong conclusions about how they got there. I’d like to see a companion piece about AOL, Yahoo, etc. There have been a heckuva lot of ‘dominant’ businesses with great market share that failed. I bet you could have said many of the same things about AOL back in the day….

  7. There is nothing unique about amazon , their marketplace can be duplicated, their aws is expensive and Google is already on the way to beat them on that area as well.

  8. I’d say that a customer always feels he is deriving more value than he is paying for. Otherwise, there would be no transaction. But definitions aside – it’s just the continuous process of refining – I got your point.

    I’ve seen Buffett metioning service and quality of product as sources of moat, which I believe is in line with your idea of “provide more value to the customer”. Turns out that something else might look more relevant depending on the business. Take GEICO. Buffett said that customers should feel the same about the service provided by different companies so they would shop for price – and then cost becomes the most important factor (which is not the same as saying that GEICO will succeed with a totally crap service as long as its price is the best). So I don’t really think there is such a thing as “Buffett Moat” or “Bezos Moat”. There is moat. Period.

    Maybe it’s confusing because of the so-called circle of competence. Buffett has long avoided some businesses – Amazon’s included – because he has no clue on how the moat of this business will look like in 10 years. So if quality of product is what matters, he can understand chocolates (Sees candy) but not AWS (Amazon). That’s why he once said that internet is not going to change how we chew gum.

    The thing is that technology has always been a moat shrinker and has never been so hard to ignore tech companies (especially for BRK, given its size). It is getting harder and harder to turn your back to tech companies/threats saying that you cannot see how the moat will be 10 years from now. It is my opinion that Buffett acknowledges this and is developing his game accordingly. So Buffett is not dumping WMT and wondering about AMZN because he sees all the “customer-centric greatness” in AMZN (even though maybe he does) but because AMZN, with its technology, is challenging WMT’s moat.

    Well, my comment is getting long so I will save my thoughts on AMZN for later. Thanks for the post!

  9. Hi John,

    Great post as always John. Amazon is a very good company and that deserve huge respect of the way it deals with its clients. though, It is really big task. Amazon figured it out early in order to gain the market share it has to gain the customers. When we shop from from a tradition store our relationship with the store is finished once we paid the bill, with Amazon the situation is totally different. I have to trust Amazon to not charge my card or sell my personal info, I have to trust Amazon to deliver my purchases and on time as it promised, I have to trust Amazon to refund my money if something is wrong. Like there is a huge trust involve and Amazon has played this game very well!

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