In a previous research note, we discussed tech billionaire Elon Musk’s recent attack on the notion of the strategic “moat,” an investment concept popularized by the wildly successful value investor Warren Buffett (Trades, Portfolio).
The long-time CEO of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) has spoken at length about the concept of the moat and how it provides enduring advantages to successful businesses. In brief, the moat is a series of structural and strategic advantages (such as low-cost production, superior efficiency or massive brand equity/goodwill) that make it more difficult for competitors (or potential competitors) to erode their profit-making machinery. These advantages form the “moat” around the “castle,” i.e., the business itself. The larger the moat, and the wider it can be expanded, the harder it is to reach the castle walls.
The concept is fairly straightforward and, as we pointed out in our previous note, rather intuitively attractive to anyone with a bent toward value investing strategies. Thus, it was a bit strange when Musk attacked the idea of strategic moats as “lame” and “sort of quaint in a vestigial way.”
Musk decried moats as being overly static defenses, while arguing that the only source of sustained competitive advantage is to lead the pace in innovation. We agreed with Musk that innovation is important, but also pointed out that moats are vital to the long-term success and positioning of a market-leading business. We would add further here that the infrastructure and culture necessary to foster and sustain innovation within a business does itself represent an element of a strategic moat.
We have already dealt with Musk’s apparent lack of understanding of, or at least lack of appreciation for, strategic moats as articulated by Buffett. But there is more to the story, as we discovered thanks to outreach from one of our readers: After Buffett responded to Musk’s poo-pooing of moats by recapitulating their value and pointing out that Musk, for all his successes as a tech disruptor, might not want to challenge Berkshire on its home turf, citing See’s candy as an example of an asset with a wide moat.
The scuffle between these two corporate titans might have ended there. But apparently Musk was not satisfied to let the matter drop. Instead, in the days after Buffett’s defense of his investment philosophy, Musk went on a Twitter tirade in which he further lampooned the idea of moats. But his tweet storm ended up going well beyond casual ribbing and joking. Indeed, Musk eventually made a striking claim: that moats are essentially unethical, sheltering oligopolies from competition.
Are moats unethical? Do they represent unfair advantage or stifle competition? Let’s address these questions in detail.
Musk tweets up a storm
Buffett’s comments about Musk’s inability to compete in the candy business seems to have struck a nerve. In a series of tweets last weekend, Musk claimed to be entering the candy business, before proclaiming his intention of building a moat of his own:
“Then I’m going to build a moat & fill it w candy. Warren B will not be able to resist investing! Berkshire Hathaway kryptonite.”
Jabs like this one, while arguably somewhat unprofessional for one of the leading lights of Silicon Valley and 21st century innovation, amount to little more than gentle ribbing. What is of actual consequence is this more direct attack on Buffett’s principle:
“Saying you like ‘moats’ is just a nice way of saying you like oligopolies.”
What Musk seems to be saying is that strategic moats constitute unfair barriers to entry, creating oligopolies that can engage in the rent-seeking behavior such market structures are well known to produce.
But is that a fair assessment?
Advantage does not mean oligopoly
Every business is out to thrive, and that usually means competing with other businesses. Competition makes every business stronger, pushing through innovations, pushing down costs and improving products and services. That is a fundamental principle of market capitalism. But it is also possible for private enterprises to obtain considerable market power, sometimes rising with a few other firms to oligopoly status, or in extreme cases rising alone as a monopoly. There are, arguably, some “natural” monopolies, such as electricity provision. But for the most part, few industries are structured in such a way that allows a small number of players, or a single player, to dominate.
Theoretically, a strategic moat could be so good that it is essentially impossible to overcome. A business with such a moat would be secure insofar as the entry of any new competitor would be blocked for being prohibitively expensive or challenging. But even the most extreme moat is not a monopoly power or an oligopoly power. Whether the moat is based on being the lowest-cost producer, or on the universal brand awareness and appeal of a beloved household name, it is not a market-distorting power. Rather, it is simply a comparative advantage. If Berkshire attempted to engaging in the rent-seeking behavior expected of oligopolistic pricing, its various moats would be swept away.
Moats are good
Here is the important distinction: Moats are maintained through excellence of product or service while oligopolies are sustained through price-fixing and manufactured structural barriers to entry. One produces virtuous cycles, the other vicious ones.
Unfortunately, Elon Musk seems to be unable to distinguish between these vitally different business models. In attacking moats, he does a disservice to investing principles and shows a startling lack of understanding.
Disclosure: I/We own no stocks discussed in this article.
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