Hallmarks of superb businesses
Competition shapes strategy which, in turn, shapes moats
Most investors are familiar with Warren Buffett’s concept of moats. Moats are also called economic moats and may be thought of as competitive barriers to entry enjoyed by a business.
In this post I propose to go back a step, and look behind the moats. Business strategies lead to the moats. We will look at the five underlying competitive forces that shape business strategy.
Asking questions in a simple five forces framework will allow us to understand what makes Warren Buffett’s moats work and where they are likely to break down.
The simple fact is that a company might enjoy a moat, let’s say a network effect, and yet be hobbled in efforts to make profitable use of it by other competitive forces. So, simply identifying a moat is not the end of the story.
Moats
Companies that enjoy moats produce a substantial return on invested capital in excess of their cost of capital for the long term and on a sustainable basis. When they are able to reinvest the excess capital thereby produced, they generate serious incremental shareholder value.
Various types of moats have been described: 1) switching costs that keep customers loyal; 2) network effects which occur when the value of a product or service increases for both new and existing users as more people use the product or service; 3) intangible assets such as patents, government licenses and brand identity; 4) Cost advantage which allows a company to undercut the competition and still make healthy profits; and 5) Efficient scale in an oligopoly or natural geographic monopoly limiting rivalry.
Competition shapes strategy which, in turn, shapes moats
In 1979 the Harvard Business Review published a ten-page article by Michael Porter in which he examined the underly competitive forces that shape corporate strategy. The article is remarkable for its clarity of writing and deep insights into the business strategies that make companies profitable. It is titled How competitive forces shape strategy.
Michael Eugene Porter is an American businessman and professor at Harvard Business School. He was one of the founders of the consulting firm The Monitor Group and FSG, a social impact consultancy.
Porter’s main thesis is that competition in an industry or sector is rooted in its underlying economics. He maintains that competitive forces exist that go well beyond what he calls the established combatants in a particular industry. For example, suppliers, potential entrants and substitute products and services are all competitors for the dollars at stake in the business at hand. He looks at what he calls the supply side and the buyer side of businesses. The supply side includes businesses that supply materials and other inputs to a company. The supply side also includes labor that supplies its services to a company.
The article was primarily written for corporate CEOs and strategists to inform the development of strategies to guide businesses. But Porter tells us that the framework he presents can also be used to predict the eventual profitability of a business or industry. The task, he says, is to examine each competitive force, assess the magnitude of each underlying cause and then construct a composite picture of the likely profit potential of the company.
What he presents is no less than a simple framework that allows us to understand what makes Warren Buffet’s moats work and where they are likely to break down
Porter says that: “The key to growth – even survival – is to stake out a position that is less vulnerable to attack from head-to-head opponents, whether established or new, and less vulnerable to erosion from the direction of buyers, suppliers, and substitute goods. Establishing such a position can take many forms – [i.e. the moat can take many forms] – solidifying relationships with favorable customers, differentiating the product either substantively or psychologically through marketing, integrating forward or backward, establishing technological leadership.”
The five forces governing competition which shape strategy which, in turn, shape moats
Here is a diagram of Michael Porter’s five forces. They all exert pressure on corporate margins and hence, on business profitability. They press from all sides and also from within any industry.
Let me adopt the description of the five forces offered in a recent Consilient Research/Morgan Stanley report dated October 15, 2024 by Michael J. Mauboussin and Dan Callahan, titled Measuring the Moat Assessing the Magnitude and Sustainability of Value Creation.
After each force is described the Consilient Report offers a Mitigant.
The Five Forces
“Threat of New Entrants Risk: New competitors erode market share and profitability. Mitigant: Establish strong barriers to entry. Theory of disruptive innovation, which describes how strong and capable incumbents get unseated by upstarts.
Rivalry Among Existing Firms Risk: Intense competition reduces profitability. Mitigant: Avoid direct competition and promote legal cooperation. Impact of oligopolies > low incentive to competition
Bargaining Power of Suppliers Risk: Strong suppliers increase input costs and squeeze margins. Mitigant: Diversify supplier base and consider vertical integration. Includes cost of labor.
Bargaining Power of Buyers Risk: Strong buyers are demanding and limit profitability. Mitigant: Differentiate and promote customer loyalty. Vs high cost of switching
Threat of Substitutes Risk: Substitutes offer products that limit industry profitability. Mitigant: Innovate, improve products, and create switching costs. New technology and obsolescence”
A case study on how Porter’s five forces come into play
The network effect is the current moat du jour. High profile companies with network-based moats inhabit the Magnificent Seven club. Meta Platforms (Facebook et al) is a prime example. Another good example is Ebay. Uber is both a network and platform company. Platform is another term that is a favorite in the world of tech. Platforms and networks often work together. Social media platform examples are Facebook, Twitter, Instagram, and LinkedIn. These platforms offer users the ability to communicate, share, and network online. E-commerce platform examples include Amazon, Bol.com, and Alibaba. These platforms enable users to buy and sell products and services online.
The network effect has been around for ages. Telephone companies are a good example from over one hundred years ago. The telephone company moats sustained on the network effect worked until they didn’t. When cell phones came along, customers started to ditch their landlines. When that happened the network effect went into reverse.
To understand how Michael Porter’s five forces can help us understand the strengths and weaknesses of a network-based moat, let’s look at the network enjoyed by a smaller, ostensibly non-tech, company: C.H. Robinson Worldwide Inc. CHRW.
CHRW’s business and moat
We can use Morningstar’s description: “C.H. Robinson is a top-tier non-asset-based third-party logistics provider with a significant focus on domestic freight brokerage (about 61% of net revenue), which reflects mostly truck brokerage but also rail intermodal. Additionally, the firm operates a large air and ocean forwarding division (27%), which has grown organically and via tuck-in acquisitions over the years.
C.H. Robinson dominates the $90 billion-plus asset-light truck brokerage industry, and its immense network of shipper-customers and asset-based truckers supports a wide economic moat, in our view. Although the company isn’t immune to freight pullbacks, its variable-cost model historically helps shield profitability during periods of lackluster volume and pricing, as evidenced by a long history of above- average operating margins.” (Emphasis added)
CHRW has a market cap of some $11 billion. It is a large company but not huge.
In the interests of full disclosure, our family owns shares in the company.
Here’s how Morningstar describes their moat. “C.H. Robinson maintains a wide economic moat thanks to the network effect. Its industry-leading network of shippers and carriers reinforces a strong value proposition, and duplication by small providers with fewer resources would be a formidable task.”
The five forces framework in action
Now let’s examine the CHRW moat through the lens of Michael Porter’s five forces governing competition.
I don’t wish to unnecessarily complicate this. But we should take note that Porter’s article also enumerates seven sources of barriers that protect incumbents. We can call them the seven Porter barriers. In effect, the seven barriers can be a source of or supplement to a company’s essential moat. So, as we think about CHRW’s moat and the five forces, we can also note as well the applicable Porter barriers.
Forces governing competition – the threat of new entrants.
The truck brokerage business is fragmented. CHRW dominates. CHRW regularly earns a Return on Invested Capital (ROIC) over 20%. This would normally attract competitors like bees to honey. This fragmented marketplace and the potential for high capital returns, are attracting competition to the truck brokerage space, including startup digital freight matching entities.
Morningstar puts it this way: “While competitors with sufficient capital can replicate technology, CHRW’s robust proprietary IT platforms provide differentiation from smaller providers with fewer resources. We expect the company to garner additional market share from less capable 3PL competitors as supply chains continue to increase in complexity, requiring sophisticated informational expertise and broad, vetted capacity relationships.”
It is this source of the moat that essentially addresses the threat of new entrants. Let’s go further, drawing on Porter’s ideas.
The high capital cost to a competitor is one of Porter’s seven sources of barrier that protect an incumbent like CHRW. The moat CHRW enjoys is based, in part, on the capital requirements of a competitor to build a competing and better network.
The main threat to their moat would probably come from some new technology in the same way cell phones displaced landlines. CHRW is already at the leading edge of tech in its business. For example, it is actively using AI to enhance its logistics operations. They have implemented generative AI to automate various tasks across the entire lifecycle of a freight shipment. This includes automating responses to emailed price quotes, setting appointments for pickup and delivery, and even collecting proof of delivery documents. At this point, it seems CHRW has competitive strategies to hold off disruptive innovation by its competitors.
Porter’s article talks about demand-side benefits of scale as a potential barrier protecting an incumbent. This is an effect that benefits a company’s customers because of the scale of the company’s customer base. CHRW has a substantial customer base of more than 40,000 shippers in its highway brokerage operations. Amazon and Walmart and CHRW enjoy what Porter calls a demand-side benefits of scale barrier that protect incumbents. This would be one of the contributing factors to a real network effect.
As well, CHRW enjoys what Porter calls a supply side economy of scale and productivity protective barrier. This is based on its relationship with a large base of carriers. CHRW has relationships with and offers access to more than 60,000 asset-based carriers (most small) across most transportation modes. This acts as a valuable source of capacity for shippers as well as a valuable source of business for carriers.
What this translates into, in the case of CHRW, is a network effect.
Other businesses might enjoy a demand side benefit of scale and/or a supply side economy of scale and productivity which might fall short of a network effect and yet provide some protection from competition.
Lastly, Porter identifies incumbency advantages independent of size as a potential barrier protecting an incumbent. Incumbency advantage independent of size would apply to things like patents, proprietary technology and knowhow, brands, other intangible assets, prime locations and so on. In this regard we can think of CHRW’s “strong technology infrastructure, coupled with a vast reservoir of market data, also enhances internal pricing decisions and improves customer connectivity and reporting.”
Forces governing competition – rivalry among existing firms.
Everything I have noted about their network seems to be apt in addressing this competitive force.
Forces governing competition – bargaining power of buyers
One negative for CHRW is the likely low switching costs for a shipper to work through another broker. Micheal Porter identifies customer switching costs as a potential barrier to competition to an incumbent. High switching costs are, after all, one of the five common moat sources.
By using the five forces framework we have had to turn our mind to whether low switching costs and the bargaining power of buyers might undermine a company’s economic moat based on a network effect.
Let’s think about that for CHRW. The buyers are CHRW’s customers. To simplify, we can focus on CHRW’s surface transportation operation which provide 61% of revenues. As noted, it has a substantial customer base of more than 40,000 shippers in its highway brokerage operations.
Ironically, low switching costs in the trucking industry probably help CHRW’s competitive position. All its competitors suffer from the same problem. As well, a well capitalized new entrant would also face the same low switching costs. Morningstar describes CHRW’s competitive position: “Its industry-leading network of shippers and carriers reinforces a strong value proposition, and duplication by small providers with fewer resources would be a formidable task.” So, while customers can cheaply switch, the prospect is not enticing.
Forces governing competition – bargaining power of suppliers.
CHRW’s suppliers include both carriers and its employee costs.
As for carriers as suppliers, CHRW procures transport capacity at both fixed and spot prices and can be affected by market cycles. As with many industries, the trucking and transportation industry suffers from significant industry cycles. In economic downturns freight dries up. Carrier capacity fluctuates based on the trucks available to carry goods and also on driver availability.
As a middleman, CHRW is to some degree insulated from price swings in transportation markets. I say, to some degree, as I write this there is currently, from a short-term point of view, excess truckload market capacity. As a result, spot and contract pricing are somewhat depressed. This has little impact on CHRW over the long term.
From the point of view of staffing and labor as suppliers to the company, CHRW’s staffing compensation policies assist in smoothing these swings. Its variable-cost model historically helps shield profitability during periods of lackluster volume and pricing, as evidenced by a long history of above- average operating margins.
Forces governing competition – threat of substitutes risk.
Substitute risk encompasses many threats. Sears, Eastman Kodak, and Nokia, were incumbents with sizable resources. They were felled by what is sometimes called disruptive innovation. In the same way that the old land line telephone companies lost their network effect when cell phones came along, one can imagine some sort of creative destruction upsetting the truck brokerage business. It might come from technology or from some sort of new business model or in some other fashion.
Substitution risk is to a large extent also covered off in the discussion of the threat of new entrants discussed above. Another possible source of substitution could come from CHRW’s customers, the shippers taking their logistics operations in house. They would save the brokerage fee, but at what cost. Truck brokerage is a classic case of outsourcing to a specialist that can do the job better and cheaper. For almost all shippers, taking the operation in house wouldn’t work.
Through the lens of Michael Porter’s threat of substitutes risk, we might conclude that the risk is low. But it was worthwhile to ask the question.
Other barriers that protect incumbents.
We have looked at CHRW as a case study as to how Porter’s five forced come into play. As we looked at each, we also considered the application of Porter’s seven sources of barriers that protect incumbents. In fact, we only identified five of these barriers enjoyed by CHRW.
As something of an aside, we can note two other Porter barrier sources that don’t seem particularly applicable to CHRW. These are: unequal access to distribution channels, and restrictive government policy. Access to distribution can be a barrier to competitors. In retail, for example, an incumbent supplier that has shelf space enjoys a barrier to a competitor that does not have such access. This is not much of a barrier. Restrictive government policy refers to licenses and permits. It is reasonably self explanatory. It would be a wonderful barrier enjoyed by a nuclear plant that has all its approvals and is up and running.
Application to other types of moats
As noted at the beginning, various types of moats have been described: 1) switching costs that keep customers loyal; 2) network effects which occur when the value of a product or service increases for both new and existing users as more people use the product or service; 3) intangible assets such as patents, government licenses and brand identity; 4) Cost advantage which allows a company to undercut the competition and still make healthy profits; and 5) Efficient scale in an oligopoly limiting rivalry.
We used CHRW, a company with a network effect moat, as a case study on how Porter’s five forced come into play. This framework led us to review CHRW’s moat and whether its was vulnerable to a Threat of New Entrants, Rivalry Among Existing Firms, Bargaining Power of Suppliers, Bargaining Power of Buyers, or a Threat of Substitutes.
We could easily use the same framework to check out any other company thought to enjoy any other kind of moat.
Conclusion
Asking ourselves questions in a simple framework based on Michael Porter’s five competitive forces allows us to understand what makes Warren Buffett’s moats work and where they are likely to break down.
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