In last week’s article we covered the value proposition of economic moats, the four horsemen of false moats and two examples of sustainable competitive advantages. In this article, I will be going through two more economic moats that are extremely hard to breach.

Moat 3: Network Effect

The network effect is by far one of the most sustainable economic moats. It can be found in industries where the value of the good or service increases with the number of people using it. In other words, the most valuable network-based products will be the ones that attract the most users, creating a virtuous cycle that squeezes out smaller networks and increases the size of dominant networks.

By virtue of its characteristic, the network effect is much more common among businesses based on information or knowledge transfer than among business based on physical capital. This is because information is what economist call a “non-rival” good.

Rival goods are goods that can be used by only one person at a time. On the flip side, non-rival goods mean that one additional person using the good does not diminish the amount available to the next person. In today’s information age, there are more and more industries that can potentially build an economic moat using the network effect. Think of social media networks (Facebook, Instagram, Twitter), payment networks (American Express, Visa, Mastercard, Paypal), ecommerce platforms (Amazon, Alibaba, Ebay) and video sharing platforms (Youtube). The greater the number of users of these platforms, the greater the content, convenience and options there are and thus the greater the value provided to all users.

Even financial exchanges benefit from network effects. As more buyers and sellers aggregate on an exchange, there is greater liquidity. The added value to users of the network is that greater liquidity leads to lower spread, which reduces costs. That’s how futures exchanges such as the Chicago Mercantile Exchange (the Merc) and the New York Mercantile Exchange (NYMEX) become so profitable with wide moats.

However, the same cannot be said about stock exchanges which have weaker moats despite having deep pools of liquidity as well. This is evident by falling returns on capital of stock exchanges in recent years as competition has moved in while futures exchanges have maintained very robust profitability. The reason for this is that futures contracts are captive to an individual exchange – if I buy a futures contract on the NYMEX or the Merc, I have to sell it there. This means that liquidity is limited to each futures exchange. Whereas for stocks, liquidity is not limited to any exchange because people can buy on one exchange and sell on another.

The takeaway here is that for a company to benefit from the network effect, it needs to operate a closed network. When networks open up, the network effect can dissipate very quickly.

One way to identify network effects is to do some financial sleuthing to see whether operating income per node (customer/branch) increases as the number of nodes increases. This may be an indication that the value proposition to customers is increasing as the network expands, thus giving the company some pricing power.

Moat 4: Cost Advantages

When it comes to cost advantages, the question is not so much whether the company has cost advantages, but whether competitors are able to replicate it. Some cost advantages can be durable while others can easily be replicated by a competitor. In order to answer this question, we have to dig deep and find out how these cost advantages arise.

Another pertinent point to be said about cost advantages is that it matters more in industries where price is a large portion of the customer’s purchase criteria. The more price sensitive the consumer is with respect to purchasing the good, the greater the value of having a cost advantage is to the company.

Without further ado, let’s talk about the four ways of getting sustainable cost advantages.

1. Process advantages

In theory, process advantages should not exist long enough to constitute much of an economic moat. After all, if a company figures out a way to deliver the same quality for cheaper, competitors are sure to try and replicate it. This does happen but in reality, it takes much longer than one might expect.

Examples of businesses that have dug moats using process advantages are Southwest Airlines and Dell. Southwest did so by flying only one type of jet, minimising expensive ground time and cultivating a thrifty employee culture. Dell cut out distributors, sold direct to buyers and kept inventory very low by building PCs to order.

The real question is not how these companies achieved the cost advantages but why competitors did not just copy them. In the case of airlines, those premium airlines were unwilling to create a culture like Southwest simply because their business is built around treating some passengers like royalty and charging them for the privilege. As for Dell, its competitors were too reliant on the resellers and retailers. In both cases, competitors would literally have to blow up their existing business in order to replicate these processes.

However, fast forward both cases, their moats are significantly weaker today than they were five or 10 years ago. This is because new competitors have entered the industry and replicated these processes. So, process-based moats are worth watching closely because the cost advantages often slips away as competitors either copy the low-cost process or invent one of their own.

2. Advantageous location

These type of cost advantages are more durable than one based on process because locations are much harder to duplicate.

Mentioned in the previous article as well, waste and aggregate produce share a unique quality – low value-to-weight ratio. Thus, it is very uneconomical to transport these goods far away. So, companies with landfills and quarries located closer to their costumers almost invariably have lower costs, which means competitors that are further away will be priced out of the market. Combine this with the fact that nobody wants more landfills and quarries than necessary in their town, both enjoy extremely strong economic moats as localised monopolies. Ironically, these businesses that people often shun make excellent investments!

3. Access to unique, world-class asset

This third type of cost advantage is typically limited to commodity producers. If a company is lucky enough to own a resource deposit with lower extraction costs than any other comparable resource producer, it will likely have a competitive advantage. One interesting example is a company called Compass Minerals, which operates in the rock-salt industry. Due to the geology and the massive size of its mine, Compass is able to produce rock salt at some of the lowest costs on the globe. Coupled with its great location that allows Compass to ship salt into the American Midwest at low cost along rivers and canals, Compass has a pretty durable cost advantage over its competitors. This is an example of how two competitive advantages can come together to create an even stronger economic moat.

Such cost advantages are not limited to companies that dig stuff out of the ground. Aracruz Cellulose, a Brazilian company, is not only the largest producer of paper pulp in the world but also the lowest cost producer. Well, when Eucalyptus trees mature in about seven years in Brazil compared with 10 years in Chile and 20+ years in America, its no wonder that Aracruz is able to produce more pulp with less capital invested than anyone else.

4. Economies of scale

When thinking about cost advantages that stem from scale, remember one thing: The absolute size of a company matters much less than its size relative to rivals. Two massive firms that dominate an industry – Boeing and Airbus for example – are unlikely to have meaningful cost advantages relative to each other.

In order to understand scale advantages, it’s important to remember the difference between fixed and variable costs. Take a local grocery store for example, its fixed costs are rent and salaries for some base level of staffing, The variable costs would be the cost of merchandise and perhaps extra compensation for high traffic times of the year. Contrast this to a real-estate brokerage office. Aside from an office, a phone, a car, and a computer, there are little fixed costs. Very broadly speaking, the higher the level of fixed costs relative to variable costs, the more consolidated an industry tends to be, because the benefits of size are greater.

Cost advantages arising from greater scale can stem from large distribution networks, manufacturing scale and dominating niche markets (it is much better to be a big fish in a small pond than a bigger fish in a bigger pond).

Although manufacturing scale tends to get all of the attention in Economics 101, cost advantages stemming from large distribution networks or dominance of a niche market are just as powerful – and, in an increasingly service-oriented economy, they are more common as well.

Some companies go one step further. By continually passing on cost advantages arising from greater scale in the form of lower prices to customers, they dig a unique moat known as scale economies shared. Lower prices results in more customers and greater spending per customer, resulting in greater scale. As the company repeatedly share the cost savings with customers, a virtuous cycle arises, creating a sustainable economic moat while continually benefitting the consumers as well. This strategy has been successfully employed by retailers such as Costco, Walmart and Amazon. These businesses focus on increasing the value proposition they bring to customers by simultaneously driving prices down and improving the customer experience. Scale begets price reductions which then begets scale. This method of creating a mutually beneficial relationship with customers is truly one of the most sustainable economic moats out there.

In this article, we have learnt that network effects can lead to a very durable economic moat and cost advantages may also be a competitive advantage in price sensitive industries. However, there is no use in knowing the theory of economic moats if we are unable to put the knowledge to use and identify companies with durable competitive advantages. Therefore, in the final article, I will be sharing where to find economic moats and how to identify them. Join my telegram channel here to make sure you don’t miss it!