With the highly acclaimed television series “Game of Thrones” beginning their seventh season in July, we are reminded of the above lesser-known Buffett quote. While there are plenty of investment firms suggesting investment in “moats”, there has been little explanation on how a company establishes a moat or, more importantly, defends one. Perhaps there are some with dragons, like Daenerys Targaryen, but we’ve not come across one.

“If you have a castle in capitalism, people are going to try to capture it. You need 2 things – a moat around the castle, and you need a knight in the castle who is trying to widen the moat around the castle.”

Warren Buffett 2013

With the highly acclaimed television series “Game of Thrones” beginning their seventh season in July, we are reminded of the above lesser‐known Buffett quote. While there are plenty of investment firms suggesting investment in “moats”, there has been little explanation on how a company establishes a moat or, more importantly, defends one. Perhaps there are some with dragons, like Daenerys Targaryen, but we’ve not come across one.

Beginning with this commentary, and over the next few months, we will begin to uncover what, in our view, makes a company a great investment.

A moat is frequently described as a competitive advantage, which is the leverage a particular business has over its direct competitors. This advantage is gained by offering clients better product value, better product quality, and/or better service. Michael Porter (author, economist, management guru and professor at Harvard Business School) argues that a competitive advantage is won by “being cheaper or by being different (which means being perceived by the customer as better or more relevant). There are no other ways.”

The architect of the “Porter’s Five Forces” model identified five factors that have an impact on a company’s profitability: customers, suppliers, substitutes, potential entrants into the industry, and competitors. They can also be used, in part, to identify attractive investment opportunities. Porter argued that “if competitive forces are intense, as they are in such industries as airlines, textiles, and hotels, almost no company earns an attractive return on investment”.

By this definition, an advantage in competitive position cannot be easily defended. If customers remain happy, if the business is focused on eliminating unnecessary costs, and is focused on continually improving its products and services, then the firm is more likely to maintain competitive leadership. Porter referred to all of the activities of a business as a “value chain” in which each link in the chain adds value the customer is prepared to pay for.

Yet, too frequently, businesses tout their particular product as a competitive advantage. While developing something new might provide initial leadership, as demand increases so will competition. There are few instances where intellectual property can be used to defend a competitive position over the long term.

Each link of Porter’s chain has to provide a value to the customer that they will pay for. That’s an interesting concept and difficult one to achieve: delighting customers, cutting costs, and investing in the business all at the same time. And meanwhile, savvy competitors are investing in their own businesses to be more competitive.

Central to the competitive strength of a particular business is intelligent, committed, and skillful management with a clear understanding of their business and how it will be developed over the coming years.

But focusing on the quarterly expectations of analysts means management isn’t focused on maintaining their market position. And leadership isn’t about collecting large salaries or perks – it’s about the ability to effectively reinvest capital to make a company tougher to compete with. That’s the “knight” Buffett refers to in the quote above.

Operating a business requiring low capital requirements to grow is the path to generating more cash than management needs to maintain their operations. The essence of free cash flow will be discussed in future commentaries. However, even those types of businesses can be run by ineffective management resulting in a deterioration of competitive position and an eventual erosion of profitability.

We have learned, after decades of research, that there are very few companies with defendable moats. Even fewer with great knights trying to “widen the moat”.