Imagine you just had great pizza in a big city and you decide to share that taste with your town where no pizza place exists. You rent out a shop, hire a good chef, buy all the ingredients, create menus and pamphlets, use your social media to market your place, and open it to the public. To your surprise, the shop is much more successful than you thought. You need to buy more raw materials and employ more people and you have to keep your shop open for longer hours to cater to your customers.
This renders many neighboring non-pizza restaurants empty. They look on as their customers go to your place. So they do the most natural thing- they decide to sell pizza too.
They introduce more choices than you, employ more people, and even spend aggressively on marketing. And before you know, your tables start going empty as customers move back to the old restaurants where they had been going for a long time. You are left with massive inventory and a lot of employees waiting for their salaries but you barely have sales to support them. Your flourishing business is forced to close.
What happened to your imaginary business happens to real businesses as well.
Capital flows in the direction of highest returns.
So when a company gets successful, competitors want a piece of that cake as well
Competitors enter the space with more resources, investments, money and brains and try to take away your share
A mediocre company would fail in the light of this new competition
So to remain successful, a company must be able to prevent itself.
For that, it needs a moat.
But what is a moat?
You might have seen a fort or a castle that looks something like this:
The trench surrounding the castle filled with water is a moat. The moat is meant to be a defensive layer for the castle. Sometimes, the moat is even dry with iron spikes. But the goal is only one- to protect the castle from enemy attack.
Similarly, a company needs an economic moat to protect itself from financial attack. This is often considered the most important thing in a company by fundamental investors like Warren Buffett, and with good reason. Without a strong economic moat, companies will falter in light of increased competition. So they may have their time in the sun for a while but they will fail as soon as their competitor gets smarter. A sustainable moat makes a company worthy of long-term investing.
How do you find the economic moat of a company?
You only have to ask these questions while analyzing the company:
"Why can’t competitors steal the market of this company? Why are customers not moving to another company? What do customers like best about this company?”
The best way to guess the economic moat of a company is looking at it through the lens of a customer. “Why do I not move away from this company? Why do I not like its competitors?”
The answer to this question is the economic moat of the company.
What are the types of economic moats?
There can be many reasons why a company is able to retain its customers. If you ask yourself why you are loyal to some companies yourself, you will realize there are generally only a few common reasons. There are largely only 5 types of economic moats:
1. Real Product differentiation:
If you are the customer of a company because it has the best product on the market, the company has real product differentiation.
A product differentiation is the most intuitive moat.
A product based on new or improved technology, better features, new materials, etc. which is of a better quality than any other in the market
But it may not be a very sustainable moat
Making the best quality product mean charging premium so the addressable market for the company reduces.
Most products can be copied and competitors will eventually catch up no matter how secretive you may keep your recipe
Constant innovation also takes a lot of investments and profits from superior products are generally short lived
So even though this may sound like the best moat, it may not be that good.
2. Brands:
We are surrounded by brands everywhere we go. There are brands on the clothes we wear, the phones we use, the coffee we drink and the burgers we eat. Companies spend exorbitantly on creating and maintaining brands, and for good reason.
Branding is also known as “Perceived Product Differentiation.”
With a brand, the product is only perceived to be different rather than actually being different.
Brands are an extremely sustainable moat since customers once locked in rarely move out. People are generally very loyal to the brands they like.
Not only that, people are also willing to pay premium only for the brand. This helps company operate on much better margins.
However, brand building is a difficult task. This takes a lot of marketing expense and not all brands actually works
But once created, a brand is hard to replace.
3. Low cost:
Another intuitive moat is low cost. If you can provide a product at the lowest price, you will be able to cut through competition
Low cost may be due to many reasons such as economies of scale which are themselves too difficult to catch up, or through a new technology, or better sourcing of raw materials, or by how the business is performed.
It is important to check how a company is able to drive costs lower.
If the method is sustainable, so is the company.
4. Locking in customers:
This is probably the strongest moat there is.
Locking in customers means making it extremely difficult for customers to move out once they get onboard. If a customer cannot move out, he will continue giving the company recurring revenue.
This is generally done by making it extremely difficult or expensive to move out.
This is often done by companies that sell services. Some of the best ways to lock in customers are:
a. Making the product such that it needs extensive client training,
b. Developing products which are integral to the customers’ business so much so that the customer cannot afford to change your product and risk any delay in its operations
c. Making your service an an industry standard, meaning if all companies in that sector use that service, your customer must keep on using it too.
d. By signing long term contracts with its customers.
5. Locking out competitors:
Locking out customers means doing something that prevents your competitors from making the same product as you.
This generally happens largely in industries like pharma or media where you cannot copy your competitors by law
This is generally achieved by using:
a. Patents
b. Licenses
c. Copyrights
d. Regulation in your favour
This is a very reliable way of preventing competition
But beware: competition can be put on bay only as long as the patent/license/regulation stays. If the regulation changes, your moat may vanish.
Bottom line:
All companies need moats to protect themselves from attack of their competitors. Without moats, a company is prone to boom and bust cycles, thus making it highly unreliable for long term investing. Moats can be of various types, each with its own pros and cons. It is important to understand what the moat of the company is, and how sustainable the moat is.
For a long term fundamental investor, an economic moat should be the first step in analyzing a company.
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