Billionaire entrepreneur Elon Musk is a risk taker. He runs technology-intensive companies like SpaceX, which manufactures and launches rockets, and Tesla, which makes electric vehicles. But will he be selling candies next?

First, the context: It all started at Tesla’s earnings call earlier this month when Musk said he thinks moats are lame. Musk was not referring to moats in the literal sense but in terms of the competitive advantages of a company. The term became popular in the world of investing after legendary investor Warren Buffett used it in 1999 to describe the kind of companies he likes. Musk further argued that if a moat is your only defence against invading armies, then you will not last long. When asked about Musk’s comments at Berkshire Hathaway’s annual shareholders meeting over the weekend, Buffett said: “Elon may turn things upside down in some areas; I don’t think he would want to take us on in candy." Berkshire Hathaway owns See’s Candy, which has 200 stores in the US. Consequently, Musk announced on Twitter that he is starting a candy company and went on to add: “Then I’m going to build a moat & fill it w candy. Warren B will not be able to resist investing! Berkshire Hathaway kryptonite …" It remains to be seen whether Musk will actually take up the challenge, but he has raised an important question for investors to ponder: Are economic moats actually important? Buffett’s track record suggests they are. Berkshire Hathaway’s compounded annual growth in book value per share between 1965 and 2017 stood at 19.1%, compared with 9.9% growth witnessed by the S&P 500—adjusted for dividends—during the same period. For the record, Tesla reported a net loss of $784.6 million in the March quarter.

Moats are important as they differentiate the business from competition and help create shareholder value in the long run. In a 1999 article, published in Fortune magazine, Buffett said: “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

A company can have different kinds of advantages compared to other firms in an industry. For instance, a company may be able to produce at a lower cost and enjoy higher margins or may have a brand value that gives confidence to consumers who, in turn, are willing to pay a premium for its products.

However, competitive advantages may not be permanent, as other firms would want to emulate them to increase margins and gain market share. Therefore, the challenge is to identify companies that will maintain the competitive advantage in the long run. This is also the reason Buffett doesn’t like buying companies in industries that are prone to significant change. In his annual letter to shareholders in 1996, Buffett, for instance, noted: “...you will see that we favor businesses and industries unlikely to experience major change. The reason for that is simple: Making either type of purchase, we are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek."

This explains why Buffett largely stayed away from new-age technology companies. However, this changed with his investment in Apple Inc. Berkshire Hathaway now owns about 5% in Apple. Buffett explained that the investment is not because it is a tech stock but because of the way the company deploys capital. In an interview to CNBC in February, he had reasoned: “Apple has an extraordinary consumer franchise."

At one level, it can be argued that Apple has certain advantages in terms of brand value and consumer experience, but it is, at the end of the day, in the tech business, which is changing rapidly. In fact, technology is also changing the way traditional businesses function. This could make stock picking more and more difficult in times to come. However, it is unlikely to undermine the importance of economic moats—both in traditional and new-age technology businesses. Even internet firms have moats. Companies like Facebook and Alphabet have built dominant positions which look unlikely to be challenged in the medium term. Companies will constantly try to gain and protect competitive advantage. However, in a rapidly changing business environment, it may not be easy for money managers to pick winners at reasonable valuations. Actually, it never was.

Should investors look at the competitive advantages of a company before investing? Tell us at views@livemint.com

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