Like a deep, broad trench that protects medieval castles from invaders, economic moats protect businesses from competitors, allowing them to prosper. In this three part series, I will be sharing why finding economic moats should be central to an investor’s analysis, examples of sustainable moats, where to find them, how to identify them and other intricacies of economic moats.
Why do economic moats matter?
Moats matter for many reasons. First, it allows a company to create more value. As economic moats prevent competitors from stealing their business, companies with strong moats are able to earn greater than average returns on investment and compound money for investors for a longer period of time. In today’s highly unpredictable world, one thing remains certain – businesses will go where the money is. Moats are thus extremely important for highly profitable companies to protect its bottom line.
Placing an emphasis on finding economic moats also enforces investment discipline, making it less likely we will overpay for a hype stock. By forcing ourselves to assess whether a company’s edge is durable, we can prevent ourselves from getting caught in a trap where we invest in a fast growing company whose competitive advantage may disappear overnight.
This brings me to my next point. Investing in companies with economic moats will lower the odds of permanent capital impairment. When a company possesses strong economic moats, it is unlikely that its revenue and earnings will take huge permanent hits due to increased competition. This protects investors from permanent capital loss.
Finally, economic moats help make a company more resilient. As companies launch new growth initiatives, there are bound to be some failures. Even when a new launch completely flops, companies with economic moats are able to fall back on its core business and their ability to generate positive returns will not be severely hindered.
With the points mentioned above, it is safe to say that all things equal, investors should be willing to pay more for a company with an economic moat than one without.
Four commonly mistaken moats
Moats are extremely hard to identify and many investors mis-identify these four characteristics as economic moats. Sad to say, chances are that they will be disappointed as competition increases.
Great products are very important to win over customers but they are not moats in and by themselves. This is especially so if others can easily copy them.
Strong market share
Bigger is not necessarily better when it comes to digging an economic moat. While there are cases where market share can help build an economic moat, it largely depends on the industry. Kodak (film), IBM (PCs), Netscape (internet browsers), General Motors (automobiles), Corel (word processing software) have shown that market leadership can be fleeting. The question to ask is not “whether a firm has high market share” but rather “how the firm achieved that share”.
Great execution (efficiency)
Being more efficient is an excellent strategy that can help improve profitability by cutting costs. However, unless it is something proprietary that cannot be copied, it is not an economic moat.
Yes, you don’t want an idiot running the firm but great managers are not economic moats. Managers come and go and as Peter Lynch once said, “go for a business that any idiot can run – because sooner or later, any idiot probably is going to run it.”
Moat 1: Intangible Assets
Brands are one of the strongest economic moats as they are notoriously hard to replicate. However, a caveat must be said here that popular brands does not necessarily endow it’s owner with a competitive advantage. Brands are only an economic moat if it increases consumers’ willingness to pay or increases customer captivity. For example, Sony is an extremely well known brand but you probably would not spend more on a Sony DVD player than one from Philips, Samsung or Panasonic. On the contrary, many would pay double to get an iPhone compared to other smartphone brands.
The second way brands can create economic moats is by increasing customer captivity. For instance, when you buy a can of coke, you know exactly what you are getting. While The Coca-Cola Company may not able to sell a can of coke for double the price of Pepsi, many people will keep choosing coke over other drinks because of the positive experience associated with the brand.
While patents can prove to be a very strong economic moat, they have finite life and can be challenged. Furthermore, they are vaguely defined and guessing which team of lawyers will win a patent battle is a game with poor odds. In general, beware of any firm that relies on a small number of patented products for its profits as any challenge may severely harm the company’s profits and will be impossible to foresee.
Patents only constitute a truly sustainable competitive advantage when the firm has a demonstrated track record of innovations as well as a wide variety of patented products. 3M for instance has thousands of patens and hundreds of products.
Otherwise, patents can only serve to give companies a head start to building other more sustainable forms of economic moats.
This advantage is most potent when a company needs regulatory approval to operate in a market but is not subject to oversight with regards to pricing. Think of utilities versus pharmaceutical companies. Utilities have near monopoly but since water and electricity are basic needs, politicians watch prices like a hawk and it is unlikely that utilities will be able to earn phenomenal returns on equity. Pharmaceutical companies on the other hand, operate in a highly regulated industry but are free to set the prices.
There are two ways to build an economic moat using regulatory licenses, either single licenses or multiple smaller, hard-to-get approvals. The bond rating industry (Moody’s), slot machine industry and for-profit education are all examples of single licenses or approvals. These regulatory licenses are extremely difficult to get, allowing them to earn much greater than average returns on capital. However, this results in an over reliance on that one license. If the government ever chooses to grant more licenses, the profitability of these companies will be severely hindered.
Multiple smaller, hard-to-get approvals thus form deeper and wider economic moats because they are unlikely to all disappear overnight en masse. Common examples would be NIMBY (”not in my backyard”) companies such as waste haulers and aggregate producers – nobody wants a landfill or stone quarry located in their neighbourhood so getting new ones approved is close to impossible. Yet, these markets are highly localised because it is not economical to transport trash hundreds of miles away and trucking aggregates 40 or 50 miles will incur too much cost for producer, pricing them out of the market. This results in a local monopoly.
Contrast this to another industry with strong NIMBY characteristics – refinery. Refined gasoline has a much higher value-to-weight ratio meaning that it can be moved very cheaply via pipelines so distance is not an issue. Thus, this form of economic moat can be found in NIMBY industries that have low value-to-weight ratio (ie transportation costs are high).
Moat 2: Switching Costs
Companies that make it tough to use a competitor’s product or service creates a switching costs. If consumers are less likely to switch, company can charge more, maintaining a high return on capital.
Switching costs come in many flavours and the following is a non exhaustive list:
- Uncertainty (consumer banks, financial services, asset managers)
- Highly integrated with a company’s processes (taxation and accounting software, data processers, back-office processing)
- Retraining costs (Adobe, Autodesk)
- High upfront costs (healthcare and laboratory equipment)
The issue with finding businesses with high switching costs as an economic moat is that it can be challenging to identify businesses with switching costs unless you use the product yourself as you need to put yourself into the customers’ shoes. Furthermore, consumer-oriented firms generally suffer from low switching costs as you can walk into another clothing store or buy another brand of toothpaste from another grocery store with almost no effort. Businesses marketing consumer goods thus have to compete on economies of scale or brand.
This means that in order to find businesses with high switching costs, investors have to look at other areas such as at the workplace instead of their personal consumption patterns.
So far, we have learnt why economic moats are so valuable, some traps when it comes to identifying economic moats and two forms of sustainable competitive advantage. In the next article, I will be covering another two highly desirable moats that investors should keep an eye out for, stay tuned by joining my telegram channel here!