An economic moat is a term often used to describe a company’s ability to sustain its competitive advantages over a long period of time. The term has been popularized by Warren Buffett, and it has been a quintessential part of its investment process. Warren Buffett has used moats as a differentiating factor in choosing investment ideas. This is because if a company has a strong everlasting moat over its competitors, it is able to sustain its market share across decades. This concept is behind some of his most well-known investments like Coca-Cola.
Understanding what is a moat
A company’s ability to differentiate itself from the competition is what gives it a competitive advantage. Some companies have momentary competitive advantages that erode over time. However, some companies often have moats that could last for centuries. This allows them to outperform the competition, and build more brand awareness and increased customer loyalty. It is dependent on several factors and depends on the competitive landscape of the industry.
Moats are often directly correlated with stellar financial performance. The reason is that the competitive advantages give them the ability to operate better than the average competitor. Over time this translates into greater shareholder returns.
Types of moat
There are a vast number of different moats that companies might have. Some of them are eroded over time, and in a few cases, they can last forever. It is important as an investor to understand the different types of moats, and how you can identify them. It is also crucial to analyze which moats might deteriorate, and which ones are long-lasting competitive advantages. Here are some of the most significant moats a company can have:
Perhaps one of the first and most important types of moats is a first-mover advantage. Initially, a company that brings a new product or service to market will benefit from the lack of competition. This is perhaps one of the moats that can easily be disrupted especially in the disruptive world we live in. However, it conveys companies with a momentary competitive advantage.
Unique product or service
Having a unique product or service is directly related to first-mover advantage. Therefore, having a unique product or service can also be a moat. If a company has a unique product or service that is very hard to replicate, it has a moat. Customers that want that product or service will have no choice but to buy it from the company. Despite the efforts, some competitors will not be able to have the same offerings, even if the cost is lower.
Switching costs are also extremely important as a business advantage. Companies will often have high or low switching costs, based on their competitiveness. If a company has high switching costs, that can be a moat. The inability of customers to switch to a competitor limits their ability to compete. However, some companies have very low switching costs that are directly related to the industry in which they operate.
Barrier to entry
Although the barrier to entry is entirely different depending on the industry, it is a moat to consider. Companies that have high barriers to entry can deter competitors from ever starting a company. This way, companies within industries with a high barrier to entry enjoy less competition. Allowing them to have increased customer loyalty and brand awareness that translates into higher recurring revenues. Industries like Pharma, and Defense are some of the best examples of high barriers to entry.
Patents that can create a moat
Since we mentioned Defense and Pharma industries, why not talk about patents. Patents can be a competitive advantage for companies. Ultimately creating moats around them. However, a company’s existence cannot depend on a single patent. However, companies that are able to successfully produce vast amounts of patents, are able to consistently have a competitive advantage. If the competition is able to copy some of those patents, their moat would erode.
Continuous innovation creates a moat
Some companies define themselves as continuous innovators. This ability to constantly create new products or services can be a tremendous advantage over their counterparts. It is also directly tied with patents and the ability to create intangible value for the business.
Brand awareness is an often misunderstood moat, but it can be extremely useful. Although brands may lose their appeal over time, some brands are able to capture customer loyalty for several decades. High-quality brands have products and services that are hard to replicate, and that continuously attract new customers. The biggest challenge for companies with this moat is to maintain the same level of brand loyalty and awareness throughout time. As new generations might not uphold the brand in the same way their parents did in the past.
Not every company is able to generate recurring revenue. It is deeply dependent on the industry and the average customer profile, in their consumer base. However recurring sales can create an enormous moat for certain companies, that reflect the high switching costs for consumers. It should always be considered depending on the industry the company operates in. Given that some industries are not able to generate constant recurring sales.
Although pricing power in itself is not a moat, companies that have sustainable moats are able to have pricing power. Companies that have competitive moats are able to increase the price of their products or services without losing any revenue. This is certainly a moat, but it is a characteristic that businesses with competitive advantages have. It allows the company to easily improve its bottom line, and remain competitive. An easy way to see if a company has pricing power is to analyze its margins over time. If their margins are increasing steadily over time, this could signal a company pricing power moat.
A company that has enough scale has the ability to be more competitive when it comes to pricing its products and services. This cost advantage is a moat that can withstand for a long time. Especially when we consider industries where the barrier to entry is high, and the ability to scale requires lots of capital. Companies in this type of scenario will have tremendous advantages over their competitors. Allowing them to price their products or services very low, might not allow competitors to compete with them.
Essential differentiated product
Companies that offer essential low-priced products or services may also have a moat. Some customers will be completely indifferent to price increases in some essential items that they desperately need. However, to truly be competitive it has to be related to high switching costs. In turn, this allows the company to have tremendous pricing power over its customers. These types of businesses also tend to have great brand awareness and customer loyalty.
Today the level of disruption in certain industries is such that companies that were once market leaders can see it vanish in a matter of years. Despite that, some industries and companies are not easily disrupted. The ability to be Undisruptable is a moat. Even in the highly disruptive technological sector, there are several companies that can hardly be disrupted. This is a tremendous competitive advantage, as it allows companies to be financially stable and retain their market share over a long time.
Although management may change, having great management lead a company can be a moat. This is particularly true when we look at the example of Berkshire Hathaway. Management is an integral part of business, and it can make a huge difference in the company’s success.
Location of the business
Having the ideal location can always be tremendously impactful on your competition. Some businesses are deeply dependent on their location, and having the best location can be a moat.
Contracts and regulations
Some companies have competitive advantages due to certain regulations. Increased regulations in a given industry may limit the ability of new companies to enter the space. An otherwise low barrier to entry may increase due to additional regulatory changes. Contracts act in a similar way. Some companies have moats due to the contracts that they hold. Situations, where governments have exclusive long-term contracts with certain companies, may give them a great advantage over the competition. This brings us to monopolies.
Certain companies hold monopolistic businesses that can be granted through certain long-term contracts. This allows them to have virtually no competitors or very little, and have tremendous pricing power. Although it is uncommon, some companies really hold very advantageous positions that do not allow the existence of competitors.
Too big to fail moat
Although this is not a competitive advantage per se, it allows these companies to have an increasing moat around them. Their importance means that they will not fail under any circumstance, and the government will assist in a worst-case scenario.
Although horizontal integration may be seen as a monopoly, vertical integration gives companies a much wider moat. It allows them to control virtually every step of the value chain creation. It is also able to control costs in a better way and usually tends to have higher margins.
As we have seen, moats are crucial for companies to remain competitive over the long term. There are several different types of moats, and some companies even have different moats around them. The ability to pick stocks that have moats will most likely generate better returns over the long term. Companies without any moats are prone to failure and tend to not be so competitive. This might ensure a poor stock performance that could seriously impact your returns. Look for companies with at least one moat that are able to sustain their market share.
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