What is an Economic Moat?
An Economic Moat is the long-term competitive advantage of a company. The term is inspired by the moat that surrounds medieval castles that protect the valuables within from invaders. A company with a strong moat possesses a competitive advantage that is strong and also sustainable.
Investors such as Warren Buffet states that buying businesses are like buying castles. He emphasized the importance of buying businesses with deep moats as they are protected from competitors and can maintain strong profits.
Why is an Economic Moat Important to Investors?
Two things that investors generally care about are the magnitude of return in excess of the cost of capital and how long the company will continue to generate large returns. To begin generating large profits, a company must first achieve a competitive advantage. The advantage can come from lower production costs, patents, or high switching cost. All of which will help a company differentiate from their competitors and retain their current customer base.
To sustain profits, the competitive advantage must be durable, in which case, it becomes a moat. A company with a moat has a service or product that competitors can not imitate. Thus, it can provide value for investors.
Quick Summary Points
- An economic moat is a durable competitive advantage that allows a company to be profitable long-term.
- A company with a moat is desirable for investors as they continue to increase in value
- Economic moats include:
- Complexity of product
- High switching costs
- Brand value
Ways to create an economic moat
Economic moats can be created in three ways:
- Production advantages
- Consumer advantages
- Brand value
A company achieves production advantages when it is able to provide a service at a lower cost to customers and protect products.
Features of companies with production advantages include:
- Complexity: Processes that are unique and difficult to imitate are good moats as they are durable and offer a competitive advantage in the long term. For example, the formula for the Coca-Cola syrup that creates the signature taste of the cola soft drink is difficult to copy. The complexity in this product ensures that other soft drinks brand will not be able to replicate the product and take away customers.
- Protection: A company’s products can be protected through patents, copyrights, trademarks, and operating rights. Patents help a company protect a product that they spent R&D funds on and allows them to keep the advantages achieved through innovation. Copyright and trademarks offer the same advantages to companies. For example, Mickey Mouse, which is copyrighted and trademarked by Disney, has been bringing in profit through merchandizes on shirts, hats, and jewelry for many years.
A company achieves consumer advantages when it is able to provide more benefit to consumers than competitors.
Features of companies with consumer advantages include:
- Habit and horizontal differentiation: When customers prefer a product to other competing products, there is horizontal differentiation. An example
- would be cigarette brands. Most cigarette smokers have a habit of purchasing from the same brand and does so often. A company that is able to build loyal customers who have a habit of buying from the same brand is able to maintain profits long term and therefore has a moat.
- Switching costs: Switching costs are costs that a customer has to bear if they want to switch to another product or service. As the switching costs increases, the customer becomes more locked into a company. Switching costs can also come in the form of loyalty points or the inconvenience of switching. For example, while there are no fees associated with the process of switching banks, it is inconvenient for a person to set up new accounts and portfolios. The inconvenience associated with the process ties a customer to their original bank.
- Network effects: The network effect occurs when the value for the company and existing customers increase as more people uses a service or product. It creates a moat since the company becomes more valuable and competitive over time. Example of companies with networking effects includes Visa, MasterCard, Microsoft, and Facebook. The Facebook app by itself does not have much value. However, as more people join Facebook, members enjoy the benefit of being able to connect with more people. As the Facebook network grows larger, there is more incentive for people to join the site.
Brand value is the idea that a company is able to generate more revenue or charge a premium because of brand recognition. This is based on the fact that customers believe there is a correlation between well-known brands and quality products. Brand value is especially important for companies that have commodified products.
For example, coffee is a commodified product, so for coffee shops to attract customers, they need to differentiate themselves through the brand. Starbucks is a company that has capitalized on the brand value their name holds. The company’s brand is based on convenience, good customer service, and innovative drinks. By developing the brand value over the last decade, Starbucks is now the “go-to” place for coffee and is able to charge a premium on their drink, which is a strong moat.
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