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When Is The Moat Gone?


Moats are not forever.

Watch convergent entrants.


Sorites paradox asks the question “when is a heap of grain not a heap anymore?” If we take away one grain is it still a heap? Does the logic extend down to the last grain? When does it transform to a non-heap? Investors have the same logical issue when evaluating a business with a moat. When does capitalism drain a moat to the point that the moat is no longer a moat? We believe that disruptive competitors negatively impact the protection of moats faster than investors revalue the equity.

Market Leadership

If a business is competing in the classical non-monopolistic model but is considered to have a strong moat, then it is likely to be an oligopoly. Market leadership which is usually dictated by the strongest brand allows the dominant firm to set quantity supplied with the other firms following. This is Stackelberg competition, a model superior to Bertrand or Cournot competition. Investors believe that market leaders have brand power and then induce pricing power as well. It should be noted that pricing in this model is superior to the Bertrand model but inferior to the Cournot market for the aggregate market because quantity is the variable used to determine price. However, the market leader will obtain more of the profit pool if superior pricing is accepted by the market. The consumer surplus is maximized through Stackelberg competition which is necessary for pricing power. The assault on the moat has traditionally been to force the economic from Stackelberg to Cournot. If this occurs, the follower can make output decisions independently of the leader.

Competing as the market leader is difficult because rational behavior is still required by the other participants to insure the maximum profit pool. The other companies must acquiesce to play a zero-sum game to obtain a Nash equilibrium where no one can be better off by changing strategy. The followers may decide to turn the game into a non-zero-sum game by undercutting prices or oversupplying quantity and reducing the aggregate market in order to attempt to take (or buy) market share or to signal to the leader their dissatisfaction.

Nash equilibriums are described at business school by neither player not having a more dominant strategy. A mathematician may argue that a pure strategy may exist that is not described as dominant. A pure strategy may produce the largest aggregate profit pool but may not appear dominant to the leader if their brand strength is being weakened. For example, a dominant strategy for the leader may be to use the “buy one get one free” strategy that utilizes a high price point but reduces the overall margin. The strategy may be dominant in some categories because it takes the customer out of the market for some period thus the competition cannot price at any level to buy share. This is not a pure strategy from a math viewpoint.

Competitive dynamics in a complex system are described by feedback loops and learning thus the owner of the moat is constantly attacked by the others but it is more of the loss of a few grains of sand rather than the pile. It is when a new disruptive competitor enters the market as a convergence player that trouble begins for the market leader. A convergence player combines two industry technologies into a product that differentiates itself from the current market. Apple’s iPhone was a convergence of telecommunications hardware and internet access which successfully disrupted the cell phone. Additionally, Apple arrived at the iPhone by beginning with the innocuous iPod for music.

New Entrant

The entrance of the convergence player transforms the market from a complex adaptive system to chaos. The market leader of cellphones was unable to utilize quantity supplied or price to have any impact on the growth of the new entrant. Furthermore, the market leader now has a price structure for today’s market but must invest in substantial R&D to have a place in tomorrow’s market. As today’s market is dwindling, the future has uncertainty for the incumbents. The moat is draining, when it is no longer considered a moat? We would argue that the emergence of a convergent product such as the iPhone turned the market where a Stackelberg strategy was dominant to one where no Nash equilibrium was present. It was acting like a Lorenz system.

Image result for lorenz attractor

The Lorenz attractor is known in common vernacular as the butterfly effect, it demonstrates how changes in initial conditions alter the outcome of a once deterministic system. Imagine the above depiction of the movement of a Lorenz attractor simulating the two grain piles growing and receding repeatedly; like our previously described corporate moat. Instead of the moat existing in a stable state, it is in a chaotic state of transformation and no longer will produce the economics of the past.

Investors are hesitant to substantially revalue market leaders as they are being disrupted. Once a valuation model is built and an investment thesis is in place, a false sense of confidence emerges. Determining if the market is undergoing a reshaping of the economics is not a common decision.

Amazon and Retailing

Convergent products will increasingly enter the marketplace. Artificial intelligence partnering with traditional products will continue to disrupt. Alexa and Echo are disruptive in telecommunications, but retail is where the disruptive impact is model changing. Market leaders will not be able to use the Stackelberg or Cournot models, they will be forced to compete in a Bertrand model. Competing on price will be there only move yet that will not assure an equilibrium because Alexa's entrance alters where the consumer’s decision resides.

Amazon has been ignored by some investors because of its high price/earning multiple. We have always maintained that it is an amalgamation of the profit pools of the industries it disrupts. As the value of the moats quickly drain out of the incumbents it migrates to the value of Amazon as if it is described by a Lorenz attractor.