What is a Moat and why is it important in investing?
What do Amazon, Apple, and Google have in common?
Apart from being some of the largest technology companies in the world, of course.
They all have what Warren Buffet referred to as economic moats.
Competitive advantage – Moat
A company’s economic moat is a long-term competitive advantage a company has over the competing firms. An economic moat can be thought of as an intangible asset – you can’t see it, but they’re key in the success of a company. An economic moat is a durable competitive advantage that sets the company apart from its peers.
Think about the wide and deep trenches surrounding the medieval castles. It protected the castle and the kingdom from enemies. That’s where the word moat originated from.
Just like the trenches, the economic moat helps the company to protect its market share and long-term profits from its competing firms.
Why are moats important?
Having an economic moat is key to the success of a company.
Take Coca-Cola (KO) for example. Their secret recipe is just one of their economic moats. And with that recipe, Coca-Cola sold its soft drinks in every part of the world. And none of their competitors could imitate Coca-Cola’s success, since they didn’t know the recipe.
There have been hundreds of soft drink manufacturers around the world since Coca-Cola first came out. But none has managed to overcome or even imitate Coca-Cola’s success.
Economic moats can help companies dominate a market, resulting in a consistent increase in long-term profits.
As an investor, investing in companies with multiple economic moats is a fail-proof way to generate maximum profits in the long run. As these companies maintain their market share, their earnings will continue to rise, so will the stock price.
How are economic moats created?
Economic moats are created when a company is able to distinguish itself from the rest of its competitors. This distinct advantage could be anything from pricing power to high switching costs.
Walmart is a great example of an older form of an economic moat. By economies of scale, Sam Wolton (Founder of Walmart), was able to grow Walmart into a retail giant, with 10,500 stores spread across 24 countries.
Economies of scale are defined as the ability of a company to sell its products at the lowest possible cost. Walmart achieved this early on in the business, thanks to its large number of stores. The key being Walmart’s ability to buy the merchandise in bulk, at significantly lower prices. As for suppliers, doing business with Walmart meant greater exposure to their products. Besides, Walmart was buying merchandise in huge quantities, which even with a discount, was profitable for the suppliers.
And this in turn allowed Walmart to sell the products at a lower price than their competitors. Thus an economic moat was achieved through economies of scale.
Types of competitive advantages
Walmart’s example shows an earlier type of economic moat. With the rise of technology, in the last decade, economic moats have been created by leveraging different aspects of a business.
Here are some of them.
A company, product, or service has a network effect when an increase in the number of users increases the value of its services. The value increases proportionally with the number of users.
An earlier form of network effect can be found on telephones. When telephones were first introduced, only a few people owned them. So there weren’t many people you could talk to using a telephone. But once more people started using it, the value of the telephone increased, as now there were more people you could talk to. So more people started buying telephones.
The same goes for social networks.
Facebook, for example, grew using this network effect. As more people started using Facebook, the company got more data on how people used the platform. That helped Facebook in making improvements, which in turn drove more people to the platform. This flywheel is the reason why Facebook has 2.85 billion users.
A network effect is an example of a wide economic moat. If a company has a wide economic moat, it means that its competitors will have a hard time entering or competing in the market.
On the other hand, if a company has a narrow economic moat, it means that the competitive advantage may not be sustainable. Or a competitor might be able to overcome the moat. An example of a narrow economic moat would be the one created with patents that expire in a year or so.
We’ve already seen how Walmart used the cost advantage to become the retail giant it is today. Similarly, companies create moats using various advantages related to cost.
Amazon, for example, created a moat for Amazon Web Services (AWS) both using economies of scale and high switching costs. We’ve already discussed economies of scale, so let’s see what switching costs are.
Switching cost is the cost that a customer incurs when switching from an existing service to a new one. Consider the example of banks. Sure, there are no fees to be paid for switching from one bank to another. But imagine the struggles of having to transfer your entire portfolio of assets. And don’t forget the paperwork. Often, the hassle is simply isn’t worth it. Thus, once a customer gets accustomed to a bank, he/she is unlikely to switch.
And the same goes for AWS. Once you get your website and other services running on AWS servers, it simply isn’t worth switching. Remember, we’re talking about large amounts of data here. Besides, AWS provides you with everything you need; machine learning, analytics, AR/VR, robotics. And the more services you use, the more difficult it is to transition to a different cloud provider.
This has helped AWS capture market share, and keep it. Even in 2021, they continue to dominate the cloud computing market with a share of 32% compared to 19% for Microsoft’s Azure and 7% for Google Cloud.
Companies can use their brand value to create a moat. Brand value is nothing but the perceived value of the company by the public. This brand recognition allows the company to charge a premium, without losing market share. This can be achieved through some form of unique value proposition, messaging, and culture.
And if they can use the brand value to create customer loyalty, it’s an added benefit. In fact, brand loyalty can ensure dominant market share and consistent revenue.
Case in point, Apple Inc.
Just to illustrate the power of Apple’s loyal customers, here is a survey by SellCell. According to the survey, 91.9% of iPhone owners plan to buy another iPhone when they next upgrade, up 1.4% from 2019.
So how exactly did Apple achieve this level of loyalty?
For starters, Apple always had a strong and unique value proposition; creating personal experiences with the help of technology. They weren’t just making smartphones and computers, they were creating iPhones and Macs.
You might argue that they are just fancy names for an average product.
But when their customers want to buy a smartphone they don’t go like “I want this because it has 4 GB RAM, Quad-core processor, and 64 GB internal storage. Instead, they think; “I want this because it’s an iPhone.
Moreover, Apple created its brand around emotion. It got to the point where having an iPhone makes customers feel sophisticated. That’s the reason Apple continues to dominate the smartphone market even when there are better phones in the market, both in terms of technology and price.
This brand value allows Apple to charge a premium price, without losing market share to its competitors. Owing to that, iPhone sales contribute to half or more than half of Apple’s overall sales revenue, in recent years. It accounted for 48.6% of Apple’s total revenue in the third quarter of the company’s fiscal year 2021.
While some companies build their brands through brand value and cost advantages others do so by leveraging internal resources, expertise, and legal protections.
These intangible assets are referred to as intellectual property.
Intellectual properties include patents, licenses, unique technology, etc. that are legally protected by intellectual property laws. This prevents competitors from replicating or using those properties. This allows companies to use these properties to create products or services, which can bring in a lot of revenue, as the competitors can’t replicate it.
Intellectual properties also include any form of copyrights and trademarks. For example, Disney has a lot of intellectual property in the form of all the animated characters it has created over the years. Mickey Mouse, one of the most popular characters in the Disney Universe, has been bringing in revenue from merchandise sales even years after the show ended.
Qualcomm is another example of a company that created a moat with intellectual property. The company has a massive patent portfolio with over 130,000 issued patents and patent applications around the world. They achieved this through huge and consistent investments in R&D over the years. The patents are mostly related to technology, such as 5G, wi-fi, Bluetooth, and mobile operating systems. This powerful moat has enabled them in achieving a 40% market share in baseband processors.
Qualcomm also licenses these technologies to other companies. And that has brought a huge source of revenue over the years. It is also a highly profitable business as the costs are limited. Qualcomm’s licensing division reported over $5 billion in revenue in 2020.
It is often difficult to identify an economic moat when it is being created. It becomes more clear in hindsight, as the company reaches major heights. But still, if you observe closely, you will be able to identify the significant advantage of a company.
An important aspect that distinguishes an advantage from a moat, is sustainability. The moat should be sustainable. If it is something competitors can replicate, the moat wouldn’t last long. And the longer the company can keep the moat, the greater the profits. So whenever looking at a company make sure the competitive advantage is sustainable.
An efficient products and services ecosystem is another sign that a company might be creating a moat for itself. Especially an ecosystem that benefits from the network effect that we discussed earlier. This is more often found in internet companies.
Another sign that a company is achieving a moat, is when the name of the product or service becomes a verb, or sometimes the category itself. Take Google for example. Nobody search for stuff on the internet anymore – they ‘Google’ it.
Successful companies are built on sustainable competitive advantages. So as an investor it makes perfect sense in looking to companies with economic moats. That’s not to say that every company that does have a moat will be a bad investment. Just that investing in companies with a moat increases the odds of substantial profits from the investment.
As a comprehensive continuation to this article, we’ll soon be releasing a book on Moats; how to identify a moat while it is being created, how to approach companies with an established moat, etc.
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