2. Which barriers last and which evaporate

Level 5: Competition and duration

The previous module ends on bad news for any optimistic valuation: high returns revert. But they revert at very different speeds, and there is a handful of businesses where they barely revert at all. The difference is not the quality of the product or the talent of the management team. It is a much colder question: what, in practice, stops somebody else doing exactly this? This module is an exercise in skepticism, because almost everything sold as a barrier is not one.

A barrier is an asymmetry, not a virtue

Bruce Greenwald boils it down to one idea worth memorizing: there is a competitive advantage when whoever is inside can do something whoever is outside cannot, or can do it a good deal more cheaply. Doing it well is not enough. If an entrant with money and patience can replicate your business and earn the same returns you do, you do not have a barrier: you have a temporary operating advantage that the competition will file away.

Out of that comes a brutally simple test, and it is the one to apply to any company whose price demands extraordinary profitability for decades. If a reasonably capable competitor decided to come after you tomorrow with enough funding, what exactly would stop it? If the answer is that we are better, there is no barrier. If the answer is that it would have to win over two hundred thousand customers at once, every one of them already wired into another system, then one is starting to appear.

The ones that really hold

There are few of them, and you recognize them by the mechanism, not by the adjective:

• Switching costs. The customer could leave, but leaving costs money, time and the risk of something breaking. The more deeply the product is embedded in the customer's daily operation, the higher the barrier.
• Network effects. The value to each user grows with the number of users already inside. Careful: it only works if users cannot comfortably sit in two places at once.
• Scale relative to a limited market. Being big in the abstract does not matter; being big relative to the size of the market you have to serve does. If fixed costs are enormous and the market will not support two players, the second one never earns them back.
• Intangibles with legal backing. Live patents, licenses, concessions, regulation that limits who may operate. They last as long as the paperwork lasts, and that date is there to be looked up.
• Structural cost advantage. Access to a resource, a location or a process the entrant cannot match however much it would like to. Being more efficient does not count: that gets copied.

The test: price, share and behavior at the bottom

A barrier is not declared in a slide deck, it is verified in how the company behaves over the years:

• Pricing power. Does it raise prices above inflation without losing volume? If holding volume takes promotions, there is no moat.
• Stable market share. In protected markets, shares move little and slowly. A share that jumps about every couple of years gives away a market that is wide open.
• Returns that hold up at the bottom. The moment of truth is not the good year, it is the bad year and the arrival of a cheap rival.

A business with spectacular margins, a wobbling share and returns that sink the moment competition appears had a following wind, not a barrier.

What gets sold as a barrier and is not

This is where most money is lost, because these four things sound like a moat and are nothing of the kind:

• Being first. The first mover's advantage is a window, not a wall. It buys time to build a real barrier, and if you do not build one, the second arrival turns up with your product improved and without your mistakes.
• A well-known brand with no pricing power. Awareness is bought with an advertising budget. A brand is only a barrier if it lets you charge more than the competition for the same thing, and keep on doing it. If the brand is famous but the price is dictated by the supermarket shelf, the brand is an expense, not an asset.
• Copyable technology. A technical advantage with no legal protection and no proprietary data lasts as long as it takes a rival to reach the same place. In sectors where talent moves between companies, that can be a year.
• Having a lot of customers. Having many is not the same as having them captive. Millions of customers who can walk out tomorrow at no cost are not a barrier, they are a list.

How long it lasts, the question almost nobody asks

Michael Porter taught us to look at the structure of the industry rather than the company in isolation, and out of that comes the nuance that closes this module: a barrier is not a permanent state, it is something that erodes at a rate. Damodaran insists that this rate is an explicit assumption in any valuation, not a technical detail.

When a price demands twenty years of extraordinary returns, it is asserting that the barrier holds for twenty years. Write it out in those words: what the barrier is, in one sentence, and what specific event would break it. If you can name neither of the two, the price rests on something you cannot even describe.

A real case: the best-selling mobile phone brand in the world

Around 2007 and 2008, Nokia was selling something like four out of every ten mobile phones on the planet. It had the most recognized brand in the industry, more manufacturing scale than anybody else and distribution in more countries than any rival. All of that read at the time as an unassailable position.

None of those assets prevented what happened. Customers bore no real cost for switching manufacturer, and scale in building handsets was no protection against a change in what the customer wanted to buy. In 2013 Microsoft announced the purchase of Nokia's phone business for a figure of the order of $7 billion, a fraction of what it had been worth a few years earlier.

Compare that with businesses where the barrier really is structural, such as the credit rating agencies or the card payment networks: there the customer does not choose freely, regulation and universal acceptance lock in both sides, and high returns have gone decades without reverting. The difference was not talent. It was the mechanism.