An essential component of Warren Buffett's investment strategy is his focus on what he calls "moats." In architectural terms, a moat is a water-filled ditch that surrounds a castle or a town to provide a defensive barrier from invaders. In business, a moat refers to a competitive advantage that allows a company to earn outsized profits. Buffett's moat still refers to a protective barrier, but instead of protecting a castle, it helps prevent a company's profits from being eroded by competitors.
Identifying businesses that have moats is central to Buffett's strategy, and his advice to company managers is to focus their efforts on making moats deeper and wider. However, not all moats look the same and evaluating a moat's durability can be challenging. Competitive advantages fall into the following broad categories: economies of scale, brand, regulatory advantages, and intellectual property in the form of trademarks or patents.
Alphabet Inc.'s Google (NASDAQ: GOOGL) has swiftly become one of the most dominant and profitable companies in the Internet software and services industry. While Google has diverse business ventures, it makes its money primarily from two core advertising enterprises: Internet search and targeted contextual advertising. Both Buffett and his investing partner, Berkshire Hathaway Inc. (NYSE: BRK.A) Vice-Chairman Charlie Munger, have commented on the strength of Google's moat. Examining the sources of Google's competitive advantage through these categories can provide insight into the sustainability of Google's dominance.
Competitive advantages that accrue from scale typically refer to supply-side advantages, such as the purchasing power of a large restaurant or retail chain. When scale advantages exist on the demand side, they are commonly referred to as network effects. Google's advantage here is significant and sustainable. A network effect is at work when a service becomes more valuable to all of its users as the service adds more users. The result can often be a winner-take-all dynamic in the industry, as is clearly the case with Google's search business. The search service improves as more searches are conducted by users, and as websites optimize themselves to be found on Google searches. Scale is also at work in Google's advertising network, which delivers advertising relevant to Internet users based on profiles of their interests. The more that Google learns about its users through their searches, the better its targeting ability becomes.
These are both huge advantages that appear difficult for any competitor to overcome. Google's market share in Internet search stands at 64%. As long as Google controls two-thirds of the market for search queries, its moat is deep and wide. The company's targeted advertising reach is even greater, addressing 92% of all Internet users in the United States.
Google's brand is unquestionably strong. The name of the company has become the commonly accepted verb for running an Internet search. However, the question of whether a competitive advantage exists thanks to the brand depends on how important the brand is to consumers in making a decision about what service to use. From this perspective, it is unlikely that Google's brand contributes significantly to its moat. Users mostly prefer Google search due to the quality and reliability of the results. Users would likely switch if another player were to overcome Google's network advantages and provide faster, more accurate results. In search, advertising and in Google's other software businesses, such as Android, Maps and Gmail, there is strong brand recognition and loyalty, which both contribute to the company's moat. The durability of these contributions is likely not as strong.
Regulating Competitive Advantages
Competitive advantages that result from regulation usually stem from some government actions that limit competitors from attacking. In Google's case, the company's market share in search and in its Android mobile operating system is so strong that regulation looms as a possible threat to the company's ability to maintain its strong profitability. Regulators in the United States and particularly in Europe are monitoring Google's business practices for anti-competitive behavior. There may be no better evidence of the strength of Google's moat than regulators actually declaring it unfair to the competition. However, looking forward, it is likely that Google's competitive advantages will have to sustain themselves in spite of regulation, rather than as a result of it.
Intellectual property, as a contributor to Google's moat, is difficult to assess. Advantages that result from intellectual property often refer to patented technology, such as drug formulas. Google owns many patents, but it is not clear that any of these patents necessarily keep competitors at bay. Furthermore, Google invests heavily in research and development (R&D), hiring elite engineers to apply their intellectual firepower to challenging problems. The ability to hire the best and the brightest is certainly a competitive advantage, but it is a product of Google's scale, not its intellectual property.
Ultimately, the core of Google is the search algorithm, which is frequently tweaked in response to changes in the Internet environment. This algorithm, and Google's ability to deliver the fastest, most comprehensive search, is fundamentally responsible for creating the scale advantages that Google enjoys today. While not necessarily protected by patents or trademarks, the accumulated knowledge and computer code that underlies Google's products would be difficult to replicate, and therefore must be considered part of the company's moat.
The Bottom Line
An important test for Buffett and Munger when assessing the durability of an economic moat is whether a competitor with a massive checkbook could replicate the business in question. By this standard, Google's moat is wide and deep. Many well-funded competitors have unsuccessfully attempted to storm Google's castle, particularly in the search business. The company's biggest threat likely comes from significant changes that may take place in how Internet users behave. For example, the company's effectiveness would be challenged if social networks became so popular that they curtailed the usefulness of Internet searches. Google must remain nimble and prepared to change with its environment to maintain and widen its advantage.