In 10 tips to be a successful equity investor, we spoke about moats. The concept of an economic moat can be traced back to legendary investor Warren Buffett who looked to invest in businesses with "economic castles protected by unbreachable moats."
Basically, an economic moat is a long-term competitive advantage that allows a company to earn oversized profits over time. Quite simply, companies with a wide moat will create value for themselves and their shareholders over the long haul.
The reason a moat is so important to investing is because a long-term investor must look beyond identifying solid businesses, or finding businesses that are growing rapidly, or buying cheap stocks. He or she needs to evaluate whether a business will stand the test of time. Any time a company develops a useful product or service, it isn't long before other firms try to capitalize on that opportunity by producing a similar--if not better--product. The rivals will eventually eat up any excess profits earned by a successful business. In other words, competition makes it difficult for most firms to generate strong growth and margins over an extended period of time.
Investors especially run into trouble when they underestimate the effects of competition by assuming that a company's prospects are more sustainable than they really are. Palm, which pioneered the personal digital assistant, or PDA, is a great example. In the late 1990s, the Palm Pilot became an exceptionally popular organizational gadget, and investors quickly caught on to this trend by bidding up Palm's market value to around $30 billion in the fall of 2000. But it didn't take long for rivals like Handspring, Sony and Hewlett-Packard to introduce their own versions of the PDA, thus taking market share from Palm and eroding its margins. By 2003, Palm's market cap stood at around $350 million. Investors at the time clearly underestimated Palm's competition.
The problem with Palm was that although the firm had built an impressive castle with nifty new technology, it couldn't build a sufficient moat to defend that castle from its rivals. That’s why investors should look for firms that have a sustainable competitive advantage--not just an interesting new product, but a unique asset that can truly stand the test of time.
A company with a wide economic moat is one best suited to prevent a competitor from taking market share or eroding its margins.
Here are some moats to help you get the picture.
1) The network effect
The network effect occurs when the value of a company’s service increases for both new and existing users as more people use the service. This is a potentially quite potent source of competitive advantage, and often applies to the first mover in an emerging technology.
Millions of buyers and sellers on eBay give the company an advantage over other online marketplaces. The more sellers there are on eBay, the more likely buyers are to find what they’re looking for at a decent price. The more buyers there are, the easier it is to sell things.
Alternatively, look at a payment network like Visa. A visa card payment is accepted because it is the card that consumers have in their wallets. And why do they carry around those particular cards? Well, that's what's accepted as payment. It’s a virtuous network. Every person that takes out another Visa credit card is adding to that network and making it more likely that the merchants are going to sign up for Visa.
Why is everyone on Facebook? Because that's where everyone else is. And the value of Facebook grows as more people join. As more customers join the network, it makes that network more valuable for other customers.
As is evident, the network effect is an effect where the value of a given network grows exponentially with each node of the network that's added. The value of that good or service increases for both new and existing users as more people use that good or service. Since a network's value increases as more people use it, the company that creates the network can create a massive economic moat.
This is a relatively rare source of competitive advantage but is also the most powerful. The companies that have this advantage tend to have relatively high levels of profitability.
2) Intangible assets
Intangible assets generally refer to the intellectual property that firms use to prevent other companies from duplicating a good or service. Patents are the most common economic moat in this category since it gives a company a legalised monopoly. In certain situations, especially in the pharmaceutical industry, if you have a best-in-class drug, and you have legalised monopoly, that gives you enormous pricing power. When patents expire, generic competition can quickly push the prices of drugs down by a huge margin.
A strong brand name can also be an economic moat. Paul Larson, when he was equity strategist at Morningstar, pointed out that a brand for a random consumer-electronics, say a DVD player, is not going to confer a company pricing power. But a brand like a Coke or a Tiffany allows them to charge that little bit of a premium that could certainly be a source of economic moat.
Copyrights, regulatory licenses, and governmental approvals also fall in this category. Some companies generate enormous profits when their products or markets are artificially protected by the government. For instance, a permit for a landfill or a casino license in an area where there are a limited number of casinos provide a competitive advantage.
3) Efficient scale
When a niche market is effectively served by one or a small handful of companies, efficient scale may be present. Larson compares it to a game of musical chairs, where all the chairs are already taken. When you have a company that's providing a service to a limited market, and there's a relatively small number of competitors supplying to that market, it may not make sense for a new competitor to enter the market, because that new competitor would destroy the returns for all the players involved.
Some markets are just natural monopolies such as International Speedway, which owns NASCAR race tracks. Chicago has a NASCAR racetrack, and the Chicago market can support exactly one NASCAR racetrack. So no one would want to build another racetrack in the market when there's already a player there. It just wouldn't make sense.
The Sydney Airport stock is a case in point. The company develops and maintains the airport infrastructure and leases terminal space to airlines and retailers at the airport at Sydney, Australia. Sydney Airport’s regional monopoly, encompassing Australia's most populous city, creates a narrow economic moat.
Midstream energy companies such as Enterprise Products Partners, a Fortune 500 company, enjoy a natural geographic monopoly. It would be too expensive to build a second set of pipes to serve the same routes; if a competitor tried this, it would cause returns for all participants to fall well below the cost of capital.
4) Low-cost producer
Firms that can figure out ways to provide a good or service at a relatively low cost have an advantage because they can undercut their rivals on price. This means that you can either charge the same price as the other competitors out there, and reap a higher profit margin, or you can charge slightly lower prices and maybe try and gain some share from competitors.
One way to get a cost advantage would be economies of scale. A bigger company can typically source things cheaper and have lower overhead costs. On the other hand, a basic materials company may have an inherently low cost. For instance, a company mining a certain geology may have a lower cost than geologies elsewhere around the world. This is an inherent cost advantage, something structural to the business, and could be a source of economic moat.
For instance, when our analyst reviewed Coal India Ltd he gave it a narrow moat, reflecting the significant cost advantage afforded by vast and relatively shallow open-cut coal mines.
5) High customer-switching costs
Our analyst believes that high switching costs underlie the narrow economic moat of Wipro, Infosys and TCS.
In the case of Wipro, the company has decades of industry experience and a trove of loyal customers that rely on the firm to provide mission-critical business processes and IT services. As for Infosys, roughly 96%-98% of revenue is from repeat business and has been around these levels for many years. TCS is focused on establishing and fostering deep customer relationships that provide it with long-dated and consistent business.
If you can make it tough for your customers to use a competitor, it's usually easy to keep ratcheting prices up just a bit year after year-which can lead to big profits.
Switching is a barrier to entry that involves an expense a customer incurs to change over from one product or service to another. If not an expense, it could be a one-time inconvenience.
Buyers in these cases often need a big improvement in either price or performance to make the switch to another product worthwhile. It may not cost a customer money to switch from one provider to another. In fact, they may actually save money by switching. But if it's going to cost them time to switch, that may increase inertia and keep them with an existing provider, and allow that provider some pricing power.
The typical example is bank deposit accounts. Those deposits tend not to turn over a whole lot simply because it costs customers time to actually switch banks.
Architects, engineers, and designers spend entire careers mastering Autodesk’s software packages, creating very high switching costs.
When it would be too expensive or troublesome to stop using a company’s products, the company often has pricing power.
