Key Concept: Economic Moat
An economic moat is a concept that evaluates the extent to which a company is protected from competition. Here's how it works.
The economic moat is a concept you might often stumble upon when reading financial analysis. But what does it mean?
The term comes from medieval castles that were defended by a deep moat, making the castle almost impossible to conquer. Some moats would be extra strong, for example very large and filled with water.
The same idea can be applied to businesses. Some businesses have no defensive layer against the competition. This gives them very little pricing power and usually very low margins and profits. Entire industries can be structured this way, like the airline industry.
When Richard Branson, the wealthy owner of Virgin Atlantic Airways, was asked how to become a millionaire, he had a quick answer: 'There's really nothing to it. Start as a billionaire and then buy an airline.'
Warren Buffet in his 1996 letter to Berkshire Hathaway shareholders
In contrast, some businesses have strong walls, but those can still be stormed by determined opponents. And some have such impressive moats that their business model is almost impervious to any outside forces.
The idea is often attributed to Warren Buffett, but it has been conceptualized by many people over time under different names. For example, the 19th century "robber barons" (Rockefeller, Carnegie, J.P Morgan, etc.) knew all about the power of monopolies, a type of moat. They established their moats by driving competitors out of business, with methods that are now largely illegal.
Why Moats Matter?
Moats are often essential to the long-term survival of a business. Free market capitalism generates wealth through endless and ruthless competition. While this can be good for society's efficiency overall, it can be deadly for individual companies (and their shareholders).
Moats are anything that can durably keep competition at an arm's length.
Except for rare cases, no moat is completely impossible to breach.
To keep with the castle analogy, a moat might be dried out, be filled with soil by assailants, and the castle finally breached.
This still requires a lot of effort and a lot of time, giving the cautious investor plenty of warning about the weakening of the once-powerful moat.
Businesses with strong moats are much more likely to survive changes in market conditions, new competitors, new technologies, or recessions.
10 Common Types of Moats
A moat is called a moat because of what it does: giving a durable edge to a business. This can be achieved in multiple ways, so there is considerable diversity in moat types. Ideally, a business will not rely on only one moat, but on several. This way, even if one loses its efficiency, the business model will still hold strong.
Below are some of the most common and important types of economic moats:
1. Economy of Scale
Being bigger is sometimes better. Larger production and more clients usually mean lower costs. Very large enterprises have a huge advantage when negotiating with suppliers of everything from subcomponents to employee health insurance, and often get far better prices than smaller, lower-volume competitors could. That gives them more pricing power.
In markets with a "winner takes all" dynamic (like e-commerce for example), size can provide protection in itself. Just think of TSMC, the leading maker of electronics chips, controlling more than 1/4 of the world market[1].
2. Switching Costs
It can very difficult or costly to change suppliers. This is especially true for very technical or unique products. In this case, consumers will stick to their existing provider, and only a vastly superior product might convince them to switch.
That moat is very frequent in B2B (Business-to-Business) software markets. For example, Enterprise Resource Planning (ERP) software is used to manage the operation of a whole company. Changing providers could take months or years and disrupt operations badly.
3. Patents, Intangible Assets, and Intellectual Properties (IP)
Patents give one company exclusive rights to a new product or process - for example, a new drug or a unique technology - to one company for a fixed period of time. This is a moat that can only be eroded by an even better innovation or technology or by the expiration of the patent or IP.
This can be non-tech companies as well, like for example, Disney or Nintendo's intellectual property rights are unique and highly valuable.
4. Capital Costs
Capital-intensive industries are difficult to penetrate. For example, a new enterprise that wanted to compete with Boeing and Airbus in the commercial aircraft market would have to invest an enormous amount of capital even to design a product, let alone produce and sell it.
5. Brand and Trademark
Some brands are so powerful that people will buy them. It can be a luxury brand, but also well-known consumer products like Coca-Cola. Competitors will need to spend a lot of money on marketing to even start threatening the position of the dominant brand.
6. Network Effect
This is when a company or its product achieves dominance in its field to an extent that draws customers automatically.
This is a common moat for social media or e-commerce companies. People shop on Amazon because all the sellers are there. All the sellers are there because everybody shops on Amazon. People use Facebook because all of their friends are there.
7. Natural Monopoly or Oligopoly
Some companies have access to an irreplaceable resource. For example, an electric company might operate a series of dams over a large river. The power will be cheap to produce, and no one else can build on the same river.
An oligopoly is when an industry is structured with only 2-4 companies dominating the markets. This can give them unique advantages and pricing power.
8. Regulatory Advantage
Some companies have been given access to special authorization their competitors lack, like a special certification or an exclusive right to exploit specific mineral deposits.
9. Political Connections
This is a more controversial moat because it can be synonymous with corruption and political risk. It can be honest as well. For example, a defense firm that understands the inner workings of the Pentagon might propose a new system that's perfectly in line with the new strategy.
10. Management and People
This is a very subjective moat, but a very real moat as well. Steve Jobs or Elon Musk are the type of leaders that propelled their companies to a level no one could imagine at the time. Or maybe a company has gathered the best minds and the best sales team in their industry, and replicating these advantages would be very costly and slow.
Judging a Moat
A moat can be a crucial factor in the future profitability of a company. It is vital to figure out if the moat is solid enough to affect your assessment of a stock's value.
Age: If a brand has been recognized for a century, it is likely that it will not go out of favor in the next 5-10 years. Alternatively, an aging patent might be expiring soon or become obsolete because of competitors' innovation.
Uniqueness: How easy or difficult would it be for a competitor to replicate the moat? If the answer is "not even possible" or "a few trillion dollars", this is a sign of a very solid and valuable moat.
Scale: When a moat is massive, it becomes obvious it will be very difficult to breach it. For example, with most of the Internet users in the world having a Facebook account, it will take years of scandals and controversy to even slow down the growth of the company.
Problems With Moats
No moat is permanently indestructible. To go back to the castle analogy, maybe bigger cannons will make this type of moat and walls completely obsolete. And a bunker is needed instead of a medieval castle. So how can moats become a problem or a risk?
Weakening Moats
So the first thing when an investor finds a business with a strong moat is to judge if the moat is stronger than ever, or getting weaker. Such weakening can be almost invisible at first but have dramatic long-term consequences.
For example, a luxury brand is slowly losing its appeal to younger generations and/or to its old fans.
Or a regulatory advantage that might be canceled due to new legislative or regulatory action.
The network effect can work during the growth period, but also in reverse during a decline. Before Facebook, there was Myspace, before Google there was Yahoo, and they went from popular to forgotten very quickly.
Complacency
A company with an old and solid moat might have gotten used to succeeding without trying too hard. A few decades down the road, it might have lost the unique touch that made it successful in the first place. The decline of the once mighty General Electric, founded by Edison in 1892, is a good example.
Declining Industry
A company may have one or several strong moats over all its competitors, but the whole industry in which it operates could be going down. There's no point in being the biggest and best steam train maker if they are being replaced by more advanced technology. Eastman Kodak's dominance of the photographic film industry provided a robust moat, but it became meaningless when digital photography took over.
Valuation
Moats are highly valuable and worth paying a premium compared to a moatless business. The most ardent fans of Warren Buffett might even refuse to buy a stock without a strong moat. Still, a moat cannot justify buying a stock regardless of price.
A good example was the "Nifty-Fifty" stocks in the 1960s. They were supposed to be very "moaty" businesses you buy and never sell. It included great companies like Coca-Cola, American Express, McDonald's, and IBM. But they were trading at such expensive prices that when the stagflation of the 1970s arrived, they dramatically underperformed the market.
A moat can justify a higher price, but not ANY price.
Conclusion
Moats are a very powerful tool that can help a company to grow and stay highly profitable. Some of the best investors (like Warren Buffett) have made a career specializing in identifying companies with strong moats and paying a relatively low price for them.
Still, beginner investors might think that a moat is required to make a good long-term investment. This is far from true.
Many cyclical businesses like commodities (mining, oil & gas) have no significant moats but can turn highly profitable with the right timing. An ultra-cheap deep value stock may not need a moat to bring a profit. A hyper-growth stock might not have the best moat but may be at the right place at the right time.
Other companies may emerge as moat breakers, offering products or services that can challenge an existing moat.
In the same way, a moat can only justify a higher price tag only up to a point. Many value investors forget that Buffett would buy moaty businesses only when they were available at an advantageous price.
So to conclude, moats are highly valuable and a powerful way to find stock likely to deliver great long-term performance. But they should not become an obsession nor justify bad risk management or abandoning margins of safety.
Could You Share This Post?
Not only will you help your friends become better investors but recommendations are the lifeblood of Stock Spotlight’s growth. A few people sharing it on Twitter can really be a huge deal in terms of driving audience growth.
Thanks!
This article originally appeared on FinMasters.com: What Is an Economic Moat