Economic Moats | Active Investors Seek Wider Moats

Investors are always on the lookout for companies that can generate superior returns on invested capital. One of the key factors that they look for is a wide, competitive moat: a sustainable competitive advantage that makes it difficult for competitors to enter the market and take away market share. This could be in the form of proprietary technology, strong brand recognition, economies of scale, regulatory barriers, or any other factor that gives the company an edge over its peers.

However, it's important to note that moats in businesses are not forever. History is littered with examples of companies — and countries — that built impregnable walls only to find them rendered useless by changing circumstances.

The Maginot Line failed

Built by France in the 1930s along the border with Germany, the Maginot Line was a 280-mile-long series of fortifications that included dozens of fortresses, underground bunkers, minefields, gun batteries, and even train lines. It was designed to be impregnable and was meant to ensure that France would never again suffer the humiliation it did in World War I.

The problem was that the Maginot Line was based on the previous war. The French assumed that the German army would invade again in the same way it did before, so they built a big wall in the same place. But the Germans had other plans. They looked at the technologies that had emerged since the first world war and developed a new model of warfare that could take advantage of them. They devised Blitzkrieg: a lightning-fast attack using tanks, motorized artillery, and armored infantry vehicles.

When the Germans invaded France in 1940, they bypassed the Maginot Line altogether. The French had not built the line in the Ardennes — a densely forested area with rough terrain and few roads — considering it impenetrable for an invading army. But the Germans used their tanks to quickly go through the Ardennes and bypass the Maginot Line. In their five-week invasion, the Germans broke through the French lines over and over, never getting bogged down in the trenches of the Maginot Line as the French had expected.

Companies must stay active

The lesson for investors is clear: Companies that have a sustainable competitive advantage today may find that advantage eroded by changing circumstances. Technological innovation, changes in consumer behavior, new regulatory regimes, and geopolitical shifts can all conspire to undermine a company's moat. It's important for investors to stay alert to these changes and adjust their investments accordingly.

For example, companies that rely heavily on intellectual property may find that their patents become obsolete as new technologies emerge. An oft-cited example here is Kodak, which had a technology moat based on its expertise in film and chemical processing that was eroded as digital cameras and smartphones gained popularity. BlackBerry's and Nokia's technology moat was destroyed by Apple launching smartphones.

New technologies can also disrupt scale and distribution moats, as with Blockbuster. Netflix started disrupting Blockbuster by shipping DVDs, as they were much more mail-friendly than video cassettes, and later successfully transitioned to streaming videos.

Companies that have benefited from economies of scale may find that new competitors can enter the market more easily thanks to changes in technology or regulation, as with telecommunication companies. In the past, telecommunication companies had a significant advantage due to their economies of scale, which allowed them to build large networks and reduce cost per unit by spreading fixed costs over a larger customer base. This created higher barriers to entry for new competitors who lacked the capital and resources to build their networks. However, new technologies like Voice over Internet Protocol (VoIP) and changes in regulations allowed for increased competition and reduced the barriers to entry, resulting in traditional telecommunication companies facing increased competition from cable companies and offerings like WhatsApp, Messenger, and Facetime from tech giants.

Multiple moats offer greater resilience

Investors should also be wary of companies too reliant on a single moat. A company that has only one competitive advantage is vulnerable if that advantage is eroded. Investors should look for companies that have multiple economic moats that reinforce each other. For example, LVMH Group, a world leader in luxury, has over 75 brands including Louis Vuitton, Christian Dior, Loewe, and Bulgari; and it recently acquired Tiffany.¹ Many of these brands have been curated over centuries and have a dedicated following. In fact, the youngest brand in its name — Louis Vuitton, Moet champagne, and Hennessy cognac — is over 150 years old! Over the years, it has built scale and resilience by adding brands to its portfolio and expanding distribution.

Being passive can be risky

Although investors should feel comfortable with LVMH's multiple moats, they should never get too comfortable. Consumers' tastes and preferences change, and that could impact the competitive position of the company. One should be willing to change their mind when facts change.

While economic moats are a key factor in generating superior returns on invested capital, investors need to be aware that moats are not forever. Companies that have a competitive advantage today may find that advantage eroded by changing circumstances. It's important for investors to stay alert to these changes and adjust their investments accordingly.

¹ LVMH represented 3.63% of Putnam International Equity Fund as of March 31, 2023.

As of March 31, 2023, Netflix was not held in the Putnam International Equity Fund.

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