- Bruce Greenwald — the Robert Heilbrunn professor of Finance and Asset Management Emeritus at Columbia Business School — shares a simple calculation for evaluating the extent of company’s competitive advantage.
- He says the first thing you should do when looking at a business is ask: “Is there a moat here?”
- Click here for more BI Prime stories.
Warren Buffett — arguably the world’s most famous investor — built his empire through the employment of a few simple strategies and concepts.
His approach is marked by the combination of a long-term time horizon, good businesses, fair prices, and a sustainable competitive advantage that have made him so successful.
However, Buffett likes to put an emphasis on that last bit: the competitive advantage. It’s something that he refers to as a company’s “moat,” which he says should be a distinct, durable business edge.
His thinking behind the idea is simple: The wider the moat and the more barriers to entry, the safer his investment is.
To the untrained eye, being able to accurately determine the extent of a company’s moat may seem more like sorcery than actual analysis. After all, every business has its own idiosyncrasies and competitive landscape.
That’s where Bruce Greenwald, Robert Heilbrunn professor of Finance and Asset Management Emeritus at Columbia Business School, comes in. He says that companies competitive moats can be analyzed in a rather simple fashion.
“You have to understand the economics of moats,” he said on the “Value Investing with Legends” podcast. “The first thing you do when you look at a business is ask: ‘Is there a moat here?'”
The presence of a moat lessens the probability of a new entrant or established firm eating into the market share or profitability of an investment. Without a sustainable competitive advantage, the value that a business creates is susceptible to erosion from the competitive landscape — and that spells bad news for investors.
“You can calculate the width of a moat,” he said.
To Greenwald, it all comes down to scale and customer captivity, or how much market share changes hands).
He provides Coca-Cola (KO) — one of Buffett’s most famous investments — as an example.
“You ask yourself first: ‘What’s the minimum sustainable scale that an entrant has to get to?'” he said. “And if you’re talking about distributing cola, it’s going to be 25% in a local market.”
He continued: “Then you ask yourself: ‘How much share changes hands every year?’ That’s customer captivity plus any price advantages you’ve got.”
Greenwald says that about 20 basis-points of market share changes hands in the caffeinated soft-drinks business per year.
“It’s going to take people 100 years to get to that 25%,” he said. “That’s a 100 year moat.”
So how did Greenwald arrive at that figure?
The analysis is simple: Divide the minimum sustainable scale (25%) by the amount of share that can be acquired a year (20 basis-points).
Utilizing this methodology, it doesn’t look like Coca-Cola’s business is going away anytime soon — and that’s precisely what Buffett identified back in 1988.
“You’re looking at customer captivity. You’re looking at proprietary technology, which gives you pricing and quality advantages,” he concluded. “But above all you’re looking for economies of scale.”
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