Why Moats Matter: The Evidence on Investment Returns

The Quantitative Evidence: Economic Moats Deliver Exceptional Returns

Research consistently demonstrates that companies with durable competitive advantages generate substantially higher returns:

Wide-moat companies outperform the S&P 500 by 2.4-6.6% annually over extended periods. From 2002-2014, wide-moat stocks delivered 15.9% annualized returns versus 9.3% for the broader market—a performance gap that compounds over time and creates generational wealth differences. ¹

Companies with sustainable competitive advantages generate higher total shareholder returns, adjusted for risk, than standard asset-pricing models suggest. This alpha represents the value of genuine moats—advantages allowing companies to earn returns above the cost of capital for longer than markets anticipate.

Why This Matters for Private Equity and Strategic Acquirers

For private equity investors, these return differentials translate directly to fund performance: a portfolio company growing at 15.9% annually versus 9.3% produces 2.6x more value over a typical 5-year hold period. Wide-moat companies lost less value during the 2007-2009 financial crisis, providing downside protection critical for fund returns. The ability to earn returns above the cost of capital enables multiple expansion at exit.

For strategic acquirers, moats determine whether acquisitions create or destroy value. Acquisitions of companies with genuine, compounding moats accelerate organic growth and expand margins. Bolt-on acquisitions lacking moats often require continuous investment to maintain position. Competition drives returns toward the cost of capital—to achieve sustainable value creation, companies must defy the powerful force of mean reversion.

Investors Who Built Fortunes Through Moat-Focused Strategies

Warren Buffett, Charlie Munger, Bill Ackman, Pat Dorsey, and Thomas Russo have all built exceptional long-term track records by making moat analysis central to their investment process—Buffett and Munger compounding Berkshire Hathaway at approximately 20% annually over six decades, Ackman's Pershing Square at 16.1% annually over 20 years. These investors appear to share a common discipline before investing: they continuously test whether competitive advantages are durable, if they are strengthening or weakening, not merely whether they exist. And if there is one thing that private equity gains advantage from its positive tailwind momentum – strengthening forces upon entry.

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Strategic Acquirer Case Study: Danaher Corporation

Danaher demonstrates how strategic acquirers systematically identify and enhance moats through disciplined Commercial Due Diligence.

Since 1990, Danaher transformed underperforming industrial companies into a global powerhouse in life sciences and diagnostics, growing EPS by approximately 10,000% and delivering over 35,000% in shareholder return – yes, you read this correctly.

Example—Danaher’s Beckman Coulter Acquisition (2011): Acquired for $8.8 billion. Moats identified and enhanced: (1) Installed base/switching costs—clinical laboratories depend on instruments; replacement requires revalidation and workflow disruption; (2) Consumables/razor-razorblade model—ongoing revenue from reagents with high margins; (3) Regulatory moat—FDA-cleared instruments create barriers; (4) Brand/quality moat—hospitals trust established brands for mission-critical equipment.² Within six months, Danaher acquired Blue Ocean Biomedical to reinvigorate Beckman's hematology business.

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Why Moats Matter in Commercial Due Diligence

Competitive advantage claims in CIMs fall into predictable patterns: "strong customer relationships," "proprietary technology," "market-leading brand," or "high switching costs." Evidence is typically limited to Management assertions, cherry-picked customer testimonials, and perhaps a few retention statistics. Rarely is the claim pressure-tested through systematic VoC research or analyzed for directional momentum.

A moat isn't a feature TargetCo owns. It's an advantage that must be renewed, tested, and re-earned in each customer interaction, product cycle, and competitive encounter.

The question for private equity investors and strategic acquirers isn't "Does TargetCo have a moat?" It's "Is TargetCo's moat still widening—or has it begun to narrow?"

Moats Are Not Moats Unless They Compound

The presence of switching costs, brand loyalty, or network effects is often treated as validation. But these attributes only matter if they're intensifying relative to customer economics, competitive alternatives, and market evolution.

A moat observed during Commercial Due Diligence is not the moat investors will exit with. Market structure shifts. Customer preferences migrate. Competitors adapt. Technology disrupts. The moat purchased may have been real—but static moats become relics.

Compounding moats create option value. Decaying moats create exit risk and returns revert to the mean.

What Moats Actually Protect

A true moat defends margin and share simultaneously by:

1. Reducing customer acquisition cost over time—trust, reputation, or ecosystem effects lower friction
2. Increasing switching cost asymmetry—harder for customers to leave than for TargetCo to expand within them
3. Compressing competitive response time—replicating TargetCo's position requires years, not quarters
4. Expanding pricing headroom—relative value creation outpaces competitive parity

If any of these dynamics are reversing, TargetCo doesn't have a moat—it has a memory of one.

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Matters Graph’s Seven Moat Diligence Framework: Compounding vs. Defending vs. Decaying

We recognize seven types of moats and a given TargetCo should be evaluated in commercial diligence as to whether these moats exist and how they are performing—i.e., are its moats compounding, defending or decaying?

• Compounding Moats (the advantage is accelerating and therefore contributes to the potential to outperform as indicated by the 6.6% annual return advantage (15.9% - 9.3%) that wide-moat stocks delivered from 2002-2014) according to Morningstar’s analysis)
• Defending Moats (the advantage is stable but not expanding)
• Decaying Moats (the advantage is eroding)

Moat Type	Compounding - Commercial Diligence Signal	Defending - Commercial Diligence Signal	Decaying - Commercial Diligence Signal
1. Switching Costs	Multi-product adoption rising; displacement cycles lengthening	Retention stable; minimal upsell	Modular usage rising; competitors offering "bridging" tools
2. Brand Equity	CAC declining; inbound share rising; price premium widening	Share stable; brand recognition high	Price premium compressing; increased spend to hold share
3. Network Effects	Value-per-user rising with scale; late cohorts outperform	Engagement stable across cohorts	Saturation visible; multi-homing increasing
4. Data Advantage	Prediction accuracy gapping vs. competitors; customers pay for insights	Data used internally; customers unaware	Competitors closing data gap via partnerships
5. Ecosystem Lock-In	Customers building custom workflows; architectural dependencies deepening	Integrations functional; some stickiness	Integrations replicated; bilateral only
6. Cost Advantage	Unit costs declining with scale; margin gap widening	Cost position stable; margins maintained	Competitors closing cost gap
7. Distribution	Channel density increasing; exclusive partnerships expanding	Distribution stable; coverage maintained	Competitors replicating coverage; channel conflicts

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If an asset, on a net basis, has compounding moats versus decaying it can be a premium asset with an extended runway for value creation.

• If moats are compounding, TargetCo may be a premium asset with an extended runway for value creation
• If moats are defending, TargetCo is likely stable—but value creation is likely capped; focus on operational improvements rather than multiple expansion
• If moats are decaying, TargetCo is in harvest mode—investment is high risk

Continue to 044, Part 2: Matters Graph’s Seven Moat Commercial Diligence Diagnostic

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¹ Source: "Sustainable competitive advantage and stock performance: the case for wide moat stocks," Applied Economics, 2016. The study analyzed Morningstar Wide Moat classification from June 2002 through May 2014, finding that wide-moat portfolios outperformed the S&P 500 and Russell 3000 indices, with higher Sharpe, Sortino, and Treynor ratios, and significantly positive risk-adjusted alphas using the Carhart four-factor and Fama-French five-factor models.

² Moat analysis for Beckman Coulter based on Danaher Corporation public filings, investor presentations, and Morningstar equity research coverage of the acquisition. Danaher's subsequent acquisition of Blue Ocean Biomedical, within six months of Beckman’s closing, is documented in Danaher's 2011-2012 annual reports.

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