How to build companies with economic moats?
When investors invest in business, they look for answers to two questions :
How to identify which businesses are great? And when is the best time to invest in these businesses, in order to maximize potential returns?
The answer to the first question lies in finding companies with economic moats, or sustainable competitive advantages. In medieval times, moats were dug around castles to prevent enemies from attacking. Similarly, economic moats protect the long term returns on investments by the world’s greatest companies.
In a famous 1999 Fortune article, legendary investor Warren Buffett wrote,
“The key to investing is . . . 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.”
Over years of looking at companies, financial services firm Morningstar has identified five major sources of competitive advantage or economic moat. Here’s a quick description of the five sources of economic moat:
Intangible assets
Intangible assets include brands, patents, or government/regulatory licenses that prevent other competitors to get involved in that business.
A brand creates an economic moat around the company when it increases the customer’s willingness to pay or prevents the customer from moving to a competitor product. A moat in form of a brand enables the company to charge premium prices and hold on to market share through repeat purchases that translate into sustainable economic profits.
Patents are a source of sustainable competitive advantage for a company. If patents protect a company’s main products, and there are no other alternatives that serve a similar need, then the company can command a pricing power for a long period while other players in the industry are legally barred from competing.
Government regulations are another intangible asset that can lead to sustainable competitive advantages if the rules make it difficult or even impossible for competitors to enter the market. Regulations are especially favorable if a company can operate like a monopoly but whose pricing is not regulated like one.
Cost advantage
Companies that can provide goods or services at lower costs have an advantage because they can beat their competitors by charging lower prices. Alternatively, they may sell their products at similar prices as their competition but achieve higher profit margins.
Economies of scale are a type of cost advantage. Companies can build economic moats around their businesses by having long term lower costs than their competitors.
An advantageous cost position can arise from process advantages, a superior location, scale, or access to a unique asset.
Switching costs
Switching costs are inconveniences or expenses a customer has to incur when they change from one product to another. Customers facing high switching costs will not change products or providers unless they are offered a large improvement in either price or performance, and even then, the risk associated with making a switch may still prevent them from changing to a competitor product.
Switching costs are expenses in the form of time, hassle, money, or risk—a customer would incur to change from one producer or provider to another.
Customers who are facing high switching costs will not change to another product even if a competitor is offering a lower price or a better-performing product or service. The improvement in performance or price must be large enough to offset the cost of switching.
High switching costs are especially prevalent and powerful when there is a high cost of failure, or the cost of the specific product or service in question is fairly insignificant relative to the value it provides to the customer.
Network effects
The network effect occurs when the value of a particular product or service increases for both new and existing users, as more people use that product or service, often creating a vicious circle that allows companies to become stronger.
The network effect is a very powerful moat and top companies have network effects in some form or another. This is the primary force behind the economic moats for powerful companies like Amazon, eBay & Facebook.
Basically, a marketplace becomes more valuable as it increases in size because as more buyers join the network, more sellers join and the process continues.
Facebook, with its one billion-plus monthly users, is another great example of the network effect in action.
Efficient scale
Efficient scale is an economic moat in which a market of limited size is served by one or a handful of companies. The companies involved generate economic profits, but potential competitors are discouraged from entering because doing so would result in insufficient returns for all players involved.
Efficient scale is not the same as cost advantage, because the leading firm’s cost advantage isn’t necessarily difficult for a potential competitor to replicate. It’s just that other potential companies have little incentive to enter the market even if they could get products at similar costs compared to the incumbent.
Often, in an efficient-scale business, the pricing power is also short to medium term. Here, the incumbent will not exercise pricing power because even though it might increase profitability, such a move will attract rival firms to enter the market and steal market share.
Using the efficient scale moat, the purpose of the incumbent is to both to make sufficient profits and at the same time keep new rivals from entering the business.
How industry giants build companies with economic moats?
Facebook & other social networks
Facebook is a great example of network effects and switching costs in action. You are on Facebook because your friends and relatives are there and so, advertisers are there. And because everyone you know is on Facebook, you wouldn’t want to move to another network and leave your fans and followers. This applies to other social networks as well. So here switching costs also come into play. Even if someone builds a better Facebook, no one will leave Facebook and join a network where their friends are missing.
Apple
Apple has many moats working for them. Their intangible assets include a strong brand and patents which protect them from competitors. Their App Store ecosystem provides them with strong network effects. The iOS operating system provides a high level of security to devices and prevents customers from moving to other cheaper brands of computers and mobile phones. Manufacturing their phones in bulk in China gives them a huge cost advantage and higher margins.
Amazon
Network effects is the primary moat for marketplaces Amazon which leads to more buyers and sellers. And because of the number of transactions, they can offer lower prices to customers. Since everything is available and since they offer great customer service, there are high switching costs as well.
Netflix
Netflix’s economic moats lie in IP and switching costs by producing the most engaging content which glues viewers to their service. The ability for Netflix to create network effects also ensures that the best creators want to be a part of Netflix because the audience is there.
Does your company appear to have at least one of the five sources of sustainable competitive advantage (intangible assets, cost advantage, switching costs, network effect, or efficient scale)?
FAQ – Investing in Businesses with Economic Moats
Q: What are economic moats in the context of investing in businesses? A: Economic moats refer to sustainable competitive advantages that protect the long-term returns on investments in businesses. These advantages are similar to the protective moats that were built around castles in medieval times to prevent enemy attacks.
Q: How can I identify businesses with economic moats? A: To identify businesses with economic moats, you can consider the following sources of sustainable competitive advantage:
- Intangible assets: Look for companies with valuable brands, patents, or government/regulatory licenses that prevent competitors from easily entering the market.
- Cost advantage: Companies that can provide goods or services at lower costs than their competitors have an advantage. This could be due to economies of scale, process advantages, superior location, or access to unique assets.
- Switching costs: Consider businesses where customers face high switching costs when changing products or providers. Customers are less likely to switch if the costs, such as time, hassle, money, or risk, are significant.
- Network effects: Companies that benefit from network effects experience increasing value as more people use their product or service. This creates a strong competitive advantage. Examples include social networks like Facebook and marketplaces like Amazon.
- Efficient scale: In markets with limited size, one or a few companies may serve the market efficiently, discouraging new competitors from entering. This can lead to economic profits for the incumbents.
Q: Why are economic moats important for investors? A: Economic moats are important for investors because businesses with sustainable competitive advantages are more likely to generate long-term profits and provide higher returns on investments. Moats protect companies from intense competition and allow them to maintain their market share and pricing power.
Q: Can you provide examples of companies with economic moats? A: Here are a few examples:
- Facebook: Facebook benefits from both network effects and switching costs. Users stay on Facebook because their friends and family are there, creating high switching costs. Other social networks face the challenge of attracting users who don’t want to leave their existing network.
- Apple: Apple has multiple moats, including a strong brand, patents, and an ecosystem with network effects through its App Store. Their iOS operating system and high-quality products create switching costs, and cost advantages come from bulk manufacturing in China.
- Amazon: Amazon’s marketplace benefits from network effects, attracting more buyers and sellers. The volume of transactions allows them to offer lower prices, and excellent customer service creates switching costs.
- Netflix: Netflix’s economic moats stem from intellectual property (IP) and switching costs. They produce engaging content that keeps viewers subscribed, and the network effects attract talented creators who want to reach the audience on the platform.
Q: Should my company have at least one of the five sources of sustainable competitive advantage? A: While having at least one of the five sources of sustainable competitive advantage (intangible assets, cost advantage, switching costs, network effects, or efficient scale) can enhance the long-term prospects of a company, it’s important to evaluate your specific business and industry dynamics. These factors are not definitive requirements but serve as indicators of a potentially stronger competitive position. Conduct a thorough analysis of your company’s unique circumstances before drawing conclusions about its competitive advantage.
