How to Choose Investments Based on Economic Moats?

how understanding benefits of economic moats can help choose investments better

The ability to defend against attack has always been beneficial. In medieval times, military strongholds such as castles used a water-filled defensive structure known as a moat to defend against or delay the advance of potential attackers. In modern times, companies also need to defend their market share from competitors by using their competitive advantage favorably. This type of competitive advantage is known as an economic moat.

Warren Buffet has defined an economic moat as the structural feature of a company that provides a competitive advantage. This enables the company to generate a high return on capital for extended periods while making it difficult for competitors to be successful. One example of a company with a successful economic moat is the Coca-Cola Company. Being one of the world’s most recognized brands, Coca-Cola products are sold everywhere in the world except Cuba and North Korea. So, any new company introducing a new carbonated beverage in the market would find it hard to displace Coca-Cola from its dominant position even if it makes substantial marketing spends. This is an example of an economic moat.

In this blog, we will discuss details of 7 types of economic moats with examples. This will help you understand the different types of competitive advantages that a company can have and help you select the best company to invest in.

  1. Intangible Assets Moat: A Competitive Advantage Built Over Time 

An intangible asset moat is an asset or attribute that provides a clear advantage to the company even though it does not have any physical existence. This type of economic moat often takes years to build and is almost impossible to replicate. In India, the name of the Tata Group is associated with trust and this is an intangible asset moat that provides a competitive advantage that will be very difficult for any other company to replicate.

This competitive advantage was not created by the marketing team at the Tata Group. Instead, Tata Group’s involvement in nation-building projects, transparent business practices, and employee-friendly practices over the past decades have played a key role in building this credibility.

Other examples of companies with intangible assets are WhatsApp, Google, and Fevicol. The products of these companies have become synonyms with the services they provide and a new company entering the space will find it difficult to challenge their dominant market position. These brand-led businesses often find it easy to retain customers, attract the best talent, and also deliver high return on capital to their shareholders.

Other types of intangible assets that can provide a competitive advantage are patents, trade secrets, and intellectual property. Companies that own patents have a strong economic moat that can generate income for up to 20 years. For example, due to the various patents that Qualcomm holds in the communications industry, it gets royalty payments for any phone manufactured and sold anywhere in the world. This royalty income is a significant contributor to the company’s annual revenue of around US$6 billion.

Coca-Cola and the formula of its signature drink is probably the best example of a trade secret. By keeping its drink formula secret, the company has ensured that none of its competitors have been able to duplicate and sell its signature drink to date.

Similarly, examples of intellectual property include copyrights and licenses that have legal protection. So, businesses that want to use protected intellectual property require prior permission for the copyrighted or licensed materials.

For example, if any company wants to use iconic characters like Mickey Mouse or Donald Duck, they will have to take prior permission from the Walt Disney Company and pay the applicable fee. Without such legal protection of its intellectual property, Walt Disney might not have become the dominant player in the entertainment industry it is today.

So, as an investor, you should seek out companies that have economic moats like patents, trademarks, trade secrets, etc. These give the companies an unmatched competitive advantage in their chosen industry.

  2.  Switching Moat: A Way For Companies to Retain Customers

If one has to incur costs to switch products/services from one company to another, then the former company has a switching moat. In such cases, the use of the term “cost” might not just be restricted to expenses and can also include the effort that the individual needs to put in to facilitate the switch. For example, even though opening a new savings account is easy, switching banks still requires some effort due to various incidental activities associated with the change.

Such additional effort may include informing the home loan company, changing auto-debit instructions of various subscriptions and Systematic Investment Plan (SIP), updating the new bank details on the Income Tax Portal, and so on.

As a result of these difficulties, a majority of individuals tend to continue with their bank account for at least 6 years before switching to a different bank.

Switching costs can be even higher in the case of bureaucratic standards. For example, many businesses might decide to retain their payroll processing company for an extended period of time. This is because such a change would require significant time and effort such as vendor selection, board approval, training of employees, etc. In this case, the current provider has a switching moat operating in its favor.

Similarly, a switching moat is also favorable for aircraft manufacturers like Boeing and Airbus, software developers like Microsoft and Oracle, banking software products like Infosys’s Finacle, and so on.  

  3.  Low-Cost Provider Moat: Keeping Costs Low To Provide Better Value

A company that is able to provide quality goods and/or services at a low cost has a competitive advantage as many customers equate a low cost to a superior overall experience. So a company with a low-cost provider moat often outperforms competitors over the longer term and provides a superior return on capital to investors. There are usually 3 key reasons for a company to emerge as a cost leader in its industry:

  • Location Advantage

Location advantage is not just about being in the right place at the right time, but can also result from being the first to market. For example, suppose an infrastructure company is the first to build a dam, power line, or road to a remote location. This helps the company achieve a competitive advantage as a competitor would not consider it profitable to replicate the effort. Another example of location advantage is the easy accessibility of raw materials such as limestone reserves for Shree Cement Limited. But apart from this easy access to raw materials, Shree Cements also has the advantage of having about 80% of its customers located within 200 kilometers of its cement manufacturing plant. This helps the company reduce transportation costs and emerge as a cost-leader in the industry.

  • Process Advantage

A company with a process advantage is one that has developed a cheaper or more efficient way of completing an operation. Examples of these include the home parties organized by Tupperware. These events provide the company with a cost-effective method to market its products. Other examples of process advantage include the business models of GEICO Insurance and Dell Computers. These companies have cut out the middlemen, which has resulted in a cost advantage for the customers. But, process advantage is usually available to companies for a limited time, and competitors often catch up after some time.

  • Economies of Scale

Economies of scale are generated by a company due to the size of its operations. Companies like Costco, Walmart, Amazon, Toyota, Maruti Suzuki, etc. are able to charge a lower price than their competitors due to increased savings generated by their high production volumes. As companies grow bigger, the benefits provided by economies of scale keep on growing.

  4. Toll Moat: The Benefits of Being a Monopoly

A business is considered to have the advantage of a toll moat if it is the only supplier of a product or service that the customer needs. Toll moats are common in the essential services sectors such as oil, agriculture, defense, railways, energy, etc., and companies operating in these sectors often have the benefit of substantial government investment.

For example, IRCTC has a toll moat as it is the only entity authorized by Indian Railways to offer train tickets online. Other examples of companies with a toll moat in India include Container Corporation of India, Coal India, and Hindustan Aeronautics Limited.

But there are companies with toll moats beyond Government-controlled companies too. Examples include Pidilite Industries and Indian Tobacco Company (ITC). Companies with this type of economic moat are undisputed market leaders in India’s adhesive and cigarettes segments respectively. While toll moats might be considered protectionist in nature, they are excellent businesses for investors seeking long-term investments.

  5. Network Effects Moat: When User Acquisition Provides Growth Momentum 

The network effect is a phenomenon in which a product or service increases in value as more and more people use it. This is an example of a positive feedback loop with an unlimited amount of momentum. For example, when Youtube was launched in 2005, it had a relatively small number of videos on its platform. But as more and more users started posting videos, even more people started searching for these videos. This increased the value of YouTube’s service and led the number of videos uploaded to the platform to grow substantially.

Other examples of companies benefiting from network effects moat are Amazon, Microsoft, WhatsApp, Twitter, and Facebook. As the number of users of these services increased through the years, these companies have appreciated in value consistently since their launch. What’s more, the larger these companies become, the more difficult it is for a new entrant to pose a serious threat to the dominance of companies that have network effects moat working in their favor.

  6. Cultural Moat: Competitive Advantage Rooted in Organizational Culture 

Even though the concept of a cultural moat is often overlooked, this type of competitive advantage can add significant value to companies and brands. A cultural moat is based on the competitive advantage that a company creates based on its value proposition, brand, and traditions.

For example, the name of TATA inspires trust, while that of the Virgin Group signifies a brand that combines multiple traits such as audacity, fun, youthful self-belief, etc. to create unique products and services. This cultural moat has helped the Virgin Group operate successful businesses in diverse industries including banking, music, airlines, aerospace, hotels, trains, and more.

  7. Digital and Data Moat: Using Emerging Technologies to Retain Market Share

In recent decades the Internet and the emergence of new technology have helped companies create economic moats through the introduction of new and unique competitive advantages. For example, in the pre-internet era, advertising was considered the key to the growth of businesses. So companies had to spend money, buy airtime, win eyeballs and build awareness so that people would be interested in buying the product or service.

Now the situation is very different as more and more companies are using content such as YouTube videos, organic search SEO pages, user-generated content, Instagram posts, Twitter threads, etc. Companies that are able to create content that reaches a wider audience by using these emerging routes are better equipped to create a digital and data moat.

Another factor that has helped in the creation of data moats is the increased use of Data Analytics. In the near future, such digital and data moats are expected to widen as Data Analytics incorporates newer technologies such as automation, artificial intelligence, and machine learning.

Companies can create digital and data moats in 3 ways:

  • Using User Data

Companies like Amazon have a significant amount of user data at their disposal. This provides the company an option to use this data in a way that creates a competitive advantage. The consumer data available with the company can be analyzed and incorporated into the company’s operating strategy. This can help the company provide a better user experience and add even more users that can increase its margins in the long term.

  • Using Data to Build Competitive Advantage

Another option that companies have is to use data to develop a core product feature to create an economic moat. For example, Netflix’s recommendation engine makes suggestions based on the likes, dislikes, and tastes of its subscribers. This ensures that users are aware of new shows and movies that are in line with their interests, which helps Netflix provide a superior user experience. Another example of this is the demand and supply matching algorithm of Uber, which is a key component of the company’s cab booking app.

  • Using Data to Create a Monetization Advantage

Some companies have managed to create a business opportunity from the user data that they have. The most commonly cited examples of this are Google and Facebook. These companies track user behavior closely and use the data to display highly targeted advertisements. Additionally, there are companies such as Netflix that use user data to create new TV shows and movies that their subscribers would enjoy. That’s why when Netflix produced a big-budget show like the House of Cards, it was reasonably sure of the show’s success based on its analysis of subscriber data.

Bottom Line

One of the key investments lessons from Warren Buffet points out that economic moats are evolving constantly and taking on new forms in line with changing market conditions. But if an investor can find a company that can maintain a distinct, durable, and sustainable competitive advantage in the long term, their investment can be hugely profitable. While such competitive advantage might not last forever, companies that use their competitive advantage to serve consumer interests are the ones that will win out in the end. So, one should seek out companies that are not complacent about their competitive advantage but are instead innovating continuously to add to their existing strengths. Investing in such companies can provide substantial returns in the long term.