The term Economic Moat refers to the ability of a company to protect its long term business prospects and its market share from its competitors. This ability could be the result of certain competitive advantages enjoyed by the company. There could be several such advantages which put a company in a dominant position. For example, a company’s large size may help it in negotiating the prices of raw material given its ability to purchase larger amounts in comparison to its competitors. A bargaining power of this nature could continue for many years since such a company could consistently offer the final product at a low cost. A value investor looks to buy stocks after a close evaluation of business fundamentals to check if a business will stand the test of time. Competitive advantages or economic moats are always a positive sign to look out for when making a stock purchase decision. If a company is generating huge profits, it will surely attract competition in the segment in which it operates. Once new competition enters, it will erode their profit. However, companies with deep and strong enough economic moats are able to hold competitors at bay and generate profits over an extended period of time.
It should be noted that competitive advantage here means “structural” competitive advantage (i.e. inherent to the business). It is critical to identify if a company actually has economic moats. Many value investors mistake ‘economic or business advantages with economic moats’. Great management, technological advancement and popular products can be advantageous to any business but none of them in real sense is a structural advantage that can promise a long sustainable return for the company of its own.
Economic moat as a value investing principle should be such that – (i) the company which manages to create it is able to reap the benefits of such an advantage for a long time; (ii) it gives the company some cushion in times of temporary setbacks in business. For example – when a corporate strategy does not work out in the short run or when the company suffers an unexpected loss due to a natural calamity.
Sources of Economic Moats in context of Value Investing
There are several ways in which a company creates an economic moat that allows it to have a significant advantage over its competitors. Such an advantage could arise from one or more of the following factors:
A company that offers a product with similar attributes as that of its competitor, but at a lower cost, enjoys a powerful economic advantage. It allows such a company to undercut competition (Read the example above). Colgate is the obvious example of this type of moat, as it can use its size to bargain price concessions from vendors which other retailers can’t match. When trying to identify such a moat, keep in mind that a company could achieve cost advantages by either inventing a better process (like manufacturing, distribution, etc) or by achieving large economies of scale. However, the low-cost advantage must be sustainable and not temporary.
High Switching Costs/locking in customers
If a company can manage to make it difficult – in terms of either money (cost) or time (inconvenience) for a customer to switch to a competing product, it can charge its customers more and make more money. A company with high customer switching cost often has a powerful competitive advantage. The most common example of this can be found in the telecom companies. The author of this article himself is fed up with his current cell-phone service provider which has bad reception and frequent call drops yet it may not be worth changing to a different service provider given the inconvenience in filling up forms for number portability or changing your phone number altogether. Sometimes the market is so used to a product, that changing to a new one is just not acceptable (even if the new product is free or better) for example – Google search instead of yahoo or Bing search engines.
A more lasting source of economic moat is product differentiation. If a company consistently produces products or services that are perceived to have different or/and better quality, then over time these differences will lead to competitive advantages for the company. Product differentiation can be real or perceived. Real product differentiation can be based on form, features, customization, performance quality durability, reliability, reparability and style. For example, the durability of Bata footwear has created the kind of product differentiation which leads to a strong moat for the company. Perceived product differentiation can be intangible assets of the company like its brand loyalty or goodwill and its reputation. For example, the brand loyalty of Colgate and Bournvita (Cadbury), give the respective companies a lasting economic moat.
High entry barriers
One of the most powerful moat is the competitive advantage enjoyed by a company which is able to put roadblocks which make it difficult or expensive for rivals to enter its market. Examples of such entry barriers include valuable patent rights such as those enjoyed by many pharmaceutical companies or trade secrets enjoyed by the cola giants, licenses and approvals to operate in highly regulated sectors for example casinos where Delta Corp in India enjoys first mover advantage in the gaming space and holds a formidable position by possessing 3 of the 6 gaming licenses issued in Goa.
Strong distribution network
Strong distribution network is yet another form of economic moat which gives a company a strong competitive advantage. A perfect example of this is the social networking company, facebook. If we look closer home, Colgate Palmolive (India) Limited is a logistical marvel with a presence in 4.85 million retail outlets out of a total of 5.72 million in India.
Economic moats are powerful and valuable assets to companies and are worth a lot when evaluating a company. A clear understanding of the concept ofeconomic moat and its effective application can prove to be extremely beneficial for investors and while there is nothing wrong in buying stocks on any other criteria (i.e. stocks which have no moats), a company with a clear competitive advantage should always be on your radar. Note that empirical evidence suggests that companies with strong economic moats are generally overvalued in terms of share price and usually trade with high Price to earnings multiples.