Robustness Ratio for Measuring Economic Moats

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In 2005, Nick Sleep and Qais Zakaria of Nomad Investment Partnership introduced a concept in their annual letter that changed how many investors think about competitive advantages.

They called it the “robustness ratio,” a simple calculation that measures the true strength of a company’s economic moat.

What Sleep discovered was that measuring how a company divides economic benefits between customers, employees, and shareholders provides deep insights into both competitive position and long-term sustainability.

This approach helps answer a key question: which businesses have moats so wide that competitors cannot cross them, even if they wanted to?

The robustness ratio measures how much money customers save compared to how much shareholders earn. Sleep defined it as:

A ratio of 1:1 means customers save one dollar for every dollar shareholders earn. A ratio of 5:1 means customers save five dollars for every dollar of profit.

The calculation works best for businesses where the customer proposition centers on price, like warehouse retailers or direct insurers. It’s less applicable for companies selling through brand power or advertising, where customers pay premiums for perceived value rather than seeking savings.

Sleep first noticed this pattern when reading Warren Buffett’s 2005 Berkshire Hathaway Annual Report. Buffett mentioned GEICO saved its customers about $1B compared to competitors while earning roughly $1B in underwriting profits.

This 1:1 split between customer savings and shareholder profits caught Sleep's attention and prompted him to examine whether other businesses displayed similar patterns of value distribution.

First, to understand how the robustness ratio works, look at GEICO’s economics in 2004:

When Sleep created a pie chart showing this division (which we’ve recreated below), GEICO’s benefits split roughly equally between customers and shareholders, with employees receiving a meaningful but smaller portion:

This robustness ratio of ~1:1 suggested a fair balance between creating customer value and generating profits.

Costco ($COST ( ▲ 0.49% )) presented a significantly different picture than GEICO. Here’s Sleep’s analysis on the average Costco cardholder in 2004:

In other words, a shopper buying $980 worth of goods at wholesale would pay $1,100 at Costco, $1,250 at Walmart, or $1,300 at Kroger. The difference comes from each retailer's markup.

After accounting for the $23 annual membership fee, Sleep estimated each Costco cardholder saved ~$150 per year compared to shopping elsewhere ($175 estimated gross savings minus $23 membership fee).

When Sleep analyzed employee compensation, he found Costco paid its workers roughly 55% more than competitors in wages and benefits. Assuming 70% of SG&A expenses went to employee compensation, Sleep calculated that Costco "overpaid" its workforce by $1.1B annually (total excess wages across all locations divided by cardholders equals $26 per cardholder).

Shareholders received the smallest slice. At $32 per cardholder pre-tax (Costco’s pre-tax profits divided by cardholder count), they earned just 15% of the total value created. Costco's robustness ratio came to ~5:1, meaning customers saved five dollars for every dollar earned by shareholders.

Here’s how this looks on a pie chart:

The gap between value creation and value extraction, relative to competitors, was substantial. You could consider it the untapped pricing power over customers that Costco chose not to exercise.

High robustness ratios create nearly insurmountable competitive barriers. For instance, Sleep calculated that for Sam's Club to match Costco's value proposition:

Even for Walmart ($WMT ( ▲ 0.52% )), with $9B in annual profits at the time, sacrificing nearly a quarter of earnings to match a competitor seemed impossible. The competitive gap becomes self-reinforcing, as Costco's scale advantages and increasing buying power allow it to widen the moat over time.

Sleep observed that Costco's model creates a virtuous cycle. Lower prices drive volume growth, which increases buying power, allowing even lower prices. The company's culture ensures these benefits flow primarily to customers rather than shareholders, making the model nearly impossible to attack.

High robustness ratios create their own risks. When companies consistently favor customers over shareholders, stock prices can stall.

From 1999 to 2005, Costco's stock traded sideways despite the business growing steadily. This worried Sleep because depressed stock prices attract private equity firms that could acquire the company cheaply through leveraged buyouts. For long-term shareholders, this meant potentially being forced to sell at low prices.

This vulnerability creates pressure to change. Sleep observed that Costco management had begun "gently tinkering" with the division of benefits (e.g., slightly raise prices and/or slow wage increases) to boost quarterly earnings and appease Wall Street. While these adjustments seem minor given the stock's poor performance, they establish a dangerous pattern.

When current management tweaks the robustness ratio to boost the stock price, they signal to future leaders that such changes are acceptable. Each new management team pushes a little further, gradually transforming a customer-first culture into a typical profit-maximizing business. The competitive advantage that took decades to build can erode quickly once this process begins.

Sleep believed there was a better solution. Instead of compromising the business model, Costco should execute aggressive share buybacks at depressed prices. This approach rewards patient shareholders who understand the model while maintaining the high robustness ratio that makes the business nearly impossible to compete against.

The robustness ratio also helps identify when companies are under-earning. In "The Capital Cycle Podcast" from Marathon, this concept was illustrated through Netflix's ($NFLX ( ▲ 1.21% )) password sharing situation.

In 2022, Netflix had 220M paying subscribers, but nearly 100M additional users accessed the service through shared passwords. The company essentially allowed these free riders to benefit without paying, significantly increasing its robustness ratio.

When Netflix cracked down on password sharing, it gained over 80M new subscribers. The incremental revenue had high flow-through to profits since the content costs were already covered.

Netflix succeeded because it merely reclaimed profits that rightfully belonged to shareholders while still offering strong value. At 14 cents per hour of viewing compared to Disney Plus at 41 cents per hour, Netflix maintained industry-leading value even after the crackdown.

The robustness ratio identifies great businesses, but valuation still matters. Marathon pointed to several cautionary examples from the late 1990s.

Warren Buffett famously called Coca-Cola ($KO ( ▲ 0.6% )) and Gillette "the inevitables" due to their strong moats and consistent value delivery. Yet investors who bought these companies at peak valuations suffered years of losses despite the underlying business strength.

Walmart ($WMT ( ▲ 0.52% )) showed similar results. Investors who purchased shares at 55 times earnings in January 2000 remained underwater for a decade. The company continued delivering tremendous value to customers and growing profits, but valuation compression overwhelmed operational performance.

Therefore, even companies with the highest robustness ratios and widest moats become poor investments at excessive prices. The robustness ratio helps you find businesses that create genuine value for customers, but you still need to buy them at reasonable prices to avoid overpaying for that value creation.