Measuring the Moat: Assessing the Magnitude and Sustainability of Value Creation

Author: Michael J. Mauboussin Published: November 1, 2016 Source: Credit Suisse Research

Overview

This seminal report establishes a systematic framework for assessing the magnitude and sustainability of value creation—the economic moat. Mauboussin argues that sustainable value creation has two dimensions: the size of the spread between return on invested capital (ROIC) and cost of capital, and how long that spread remains positive.

"For me, the key is figuring out how large a company's moat is. What I love is a big castle with a wide moat filled with water bugs and crocodiles." — Warren Buffett

Executive Summary

• Sustainable value creation has two dimensions: the magnitude of the spread between ROIC and cost of capital, and the duration that spread remains positive
• Relying solely on management skill to create sustainable value is rare; competitive forces drive returns toward cost of capital
• Industry effects are most important for sustaining outperformance, while company-specific factors dominate for underperformers
• Economic moats are rarely stable—they either widen or narrow a little every day

The Two Dimensions of Value Creation

Magnitude: The Return Spread

The gap between return on invested capital (ROIC) and the cost of capital determines how much value a company creates. Only when ROIC exceeds cost of capital does growth create value.

Duration: The Competitive Advantage Period (CAP)

How long a company can maintain returns above cost of capital. This dimension is often underappreciated by investors and executives, yet it's critical for long-term value creation.

The Competition Lifecycle

Companies typically pass through four stages:

1. Innovation — Rapid ROIC growth, many entrants
2. Return Decline — High returns attract competition, returns converge to cost of capital
3. Mature — Returns equal industry average
4. Below Average — Forces cause returns below cost of capital

Mean Reversion

Mean reversion is a powerful force. Key findings:

• Companies maintaining above-average returns for extended periods are rare
• High absolute returns combined with high investment levels correlate with faster competitive erosion
• Return persistence is shrinking across industries due to accelerated innovation and信息技术

"Companies that generate returns significantly above cost of capital attract competition that erodes those returns."

Industry Analysis

Three Steps to Industry Analysis

1. Understand the situation — Create industry maps, build profit pools, measure stability
2. Assess industry attractiveness — Analyze through Porter's Five Forces, focusing on barriers to entry and rivalry
3. Consider disruption — Evaluate threats from disruptive innovation

Industry Classification

Industries can be classified as:

• Emerging — High uncertainty, many entrants
• Mature — Stable competition, returns converge to cost of capital
• Declining — Negative returns, consolidation
• Global — Subject to cross-border competition dynamics

Porter's Five Forces

While all five forces matter, Mauboussin emphasizes that new entrant threat and rivalry are most critical:

• Supplier Power — Concentrated suppliers, high switching costs
• Buyer Power — Concentrated buyers, information advantages
• Threat of Substitution — Limits pricing power
• New Entrant Threat — Barriers to entry protect incumbents
• Rivalry — Number and similarity of competitors

Three Sources of Value Creation

1. Production Advantage

Companies create value through lower costs than competitors:

• Process advantages — Proprietary technology, economies of scale
• Asset specificity — Unique assets that competitors can't replicate
• Protected processes — Patents, copyrights, trade secrets

2. Consumer Advantage

Companies create value when customers pay more than competitors:

• Habit and lateral differentiation — Customer loyalty
• Experience goods — Products requiring trial to evaluate
• Switching costs — Customer lock-in increases willingness to pay
• Network effects — Value increases with users (e.g., Visa, Microsoft)

3. External Advantage

Government-related factors:

• Subsidies, tariffs, quotas
• Competition regulations
• Environmental regulations

Company Interaction: Game Theory

The Prisoner's Dilemma in Business

Companies frequently face the prisoner's dilemma in pricing and capacity decisions. The Nash equilibrium (defection) is often worse for all than coordinated cooperation would be.

Key insight: Most companies fail to adequately consider competitor responses when making investment decisions.

Repeated Games and Tit-for-Tat

Robert Axelrod's research showed that tit-for-tat strategies succeed in repeated games:

1. Start with cooperation
2. Mirror competitor's last move
3. Requires clear signals of competitor intent

Brand and Value Creation

Brand alone is insufficient for competitive advantage. Interbrand's most valuable brands show weak correlation between brand strength and economic returns.

The correct framework: Brand represents "getting a job done" for customers. Brands that reliably and efficiently完成工作 create sustainable value.

Management Skill vs. Luck

Research by Raynor and Ahmed (2010) studied 25,000+ companies over 44 years. Key finding: Much of apparent superior performance is due to luck, not skill.

Their advice for sustainable outperformance:

1. Differentiate, don't compete on price — Compete on differentiation, not cost
2. Grow revenues, not cut costs — Focus on increasing the pie rather than taking share

Buffett on Economic Moats

"The key to investing is not assessing how an industry is going to affect society... but determining the competitive advantage of any given business and asking how long that moat can be widened and deepened."

"Economic moats are rarely stable. They either widen or narrow a little bit every day."

Key Frameworks Summary

Framework	Purpose
Competition Lifecycle	Understand stage of industry development
Five Forces	Assess industry attractiveness
Value Creation Sources	Identify production vs. consumer advantages
Profit Pool	Track value distribution and migration
Game Theory	Anticipate competitor reactions

Related Concepts

• moat — Core concept
• michael-mauboussin — Author
• competitive-advantage — Related concept
• intrinsic-value — Related concept

Source

Credit Suisse Research, "Measuring the Moat: Assessing the Magnitude and Sustainability of Value Creation," November 1, 2016.