Operational Moat vs. Intrinsic Moat

A lot has been made of "moat" in the last decade and how it protects a company's return on invested capital.

Moat is the guard that stops other companies from stealing your profits.

Any company that consistently generates above-average returns on invested capital has some kind of moat.  If it did not have a moat, then others would jump into the same business and take the profits and the return on invested capital would decrease.

The idea is that a company or brand is so entrenched competitively that it cannot stop making a profit.

Of course this is not true absolutely and on an infinite scale because all companies may eventually lose their competitive edge because of society's changes or poor management, and profit margins are constantly under attack through competition from others.

However it is true that some companies are so competitively entrenched and fortified that it would take years of poor management and poor capital allocation to erode their profit margins.  These tend to be the companies with high brand recognition and brand loyalty.  Obvious examples being Coca Cola, Pepsi, Doritos, Cheez-Its, Charmin, Dawn, etc.

The idea is that customer goodwill and brand awareness has been built steadily over a number of years, so that the brand will continue to have a positive perception among its customers regardless of current lazy or incompetent management.  These brands have intrinsic moat.

On the other hand, companies may also generate high return on invested capital through operational moat.  This is the moat generated by the current managers of the company being more competent than the managers of the company's competitors.

Whether a company has operational or intrinsic moat depends on the economics of the business and customer's loyalty to the brand.  Businesses in industries with low fixed costs, uniform products, control over their supply, high profit margins and high customer loyalty tend to have high intrinsic moat.  It is hard for competitors to take their profits because the businesses have huge marketing budgets and the customers won't easily switch.

In capital-intensive industries with low switching costs, a company that is achieving consistent profits likely has operational moat because of the intelligence of its management.  This is a more risky investment, because the operational moat could evaporate if management leaves.

But a sustained period of operational moat can actually turn into intrinsic moat.  Some examples: Google - search engine industry has very low switching costs, but through years of operational excellence, Google has built a loyal customer base that only uses Google searches and is unlikely to switch search providers.  Apple - through operational excellence and innovation, has created millions of loyal customers who will buy iPhones for the rest of their lives.  Facebook - through constant innovation and implementation of new features, has created billions of users that use Facebook as their primary means of online social communication.  Wal Mart - a capital intensive retail business that created millions of loyal customers through its low-pricing strategy.  McDonald's - another capital-intensive and low-margin business, that created high return on invested capital through years of effective marketing and strategic real estate purchases.

I am only using large company examples here, but many small companies also have moats based on their operational excellence.

Operational moats can result in high return on investment if the management sticks around.  Intrinsic moats tend to last longer than operational moats, but not always.  No company is protected forever by its moat.