Economic moats are one of the key aspects of any great business success, but what exactly does it mean, and how do companies build them?
Economic moats are structural & sustainable qualities inherent to a business. The term was popularized by Warren Buffett and refers to the ability of a business to maintain a competitive edge over its competitors, driving long-term earnings and market share which is further reflected in the price of the stock.
Pat Dorsey, who was previously heading the research team at Morningstar (NASDAQ: MORN), explained this in his book the little book that builds wealth. Dorsey explained four kinds of moats that he looks at while analyzing companies from a long term perspective:
1. Intangible Assets: The first kind is intangible assets like brand value, patents or regulatory licenses. A brand is valuable if a customer is willing to pay more or purchase it with regularity. The popularity of the brand here matters much less. For example, Coca-Cola (NYSE: KO) as a soft drink is widely known around the world but it doesn’t cost more than a Pepsi (NASDAQ: PEP). Companies in industries like semiconductors and pharma are particularly well known for carrying a portfolio of patents. The very famous patent that Intel (NASDAQ: INTC) had on x86 (Microprocessor design), which it only licensed to AMD (NASDAQ: AMD), is one of the best examples as these two dominated the industry for years with an enormous market share.
2. Switching Cost: Pat describes this in a simple question “Does the cost of switching to a competing product or services outweighs the benefit ?” If the answer is yes, the business has a moat. U.S. commercial banks like JP Morgan Chase (NYSE:JPM), Bank of America (NYSE:BAC) & Citi Group (NYSE:C), etc. have an average turnover rate of 15%, which implies that an average customer keeps their account for 6-7 years. That sounds reasonable as banks don’t vary a lot in terms of their features, and even if they do, a lot less people are willing to go through that process of changing bank accounts.
3. The Network Effect: Businesses that offer a product or a service whose value increases with the number of users are the ones that benefit from a network effect. This may sound simple but is rare. Take American Express (NYSE:AXP), for example. It is accepted in over a million places around the world and has a huge network of merchants. This is what gives it a competitive edge over others. The more places you can use it, the more valuable it gets. That’s why in the past it really pushed to get accepted by smaller merchants. The network effect creates a barrier to entry for new firms that’s why the credit card space in the U.S is much less crowded as the 4 biggest players — American Express, Visa (NYSE:V), MasterCard (NYSE:MA) & Discover (NYSE:DFS) — account for more than 80% of the total credit card spending.
4. Cost Advantages: All kinds of competitive advantages we’ve discussed so far involve value creation by charging a premium price to the industry. Companies can also dig a moat around them by competing on the costs. There can be four sources for cost advantages: cheaper processes, better locations, unique assets, and greater scale. Dell (NYSE: DELL) & Southwest Airlines (NYSE:LUV) are the best examples of the process-based cost advantage. Dell was able to reduce costs by removing distributors for years & Southwest filled its planes with more seats and made sure each flight was packed. Cost advantages can be extremely powerful sources of value creation, but only some of them last long. Even in these two cases, competitors like HP (NYSE:HPQ) & Ryanair (LON:RYA) have followed up on the concept and the moats didn’t last long.
In his book, Pat Dorsey mentioned that investment managers these days are more concerned about job reports, Federal Reserve meetings, and quarterly earnings — all of which have little bearing on the long term value of individual companies. If investors try to find a competitive business at a reasonable price for the long term, they can successfully make decent returns on capital.
MyWallSt operates a full disclosure policy. MyWallSt staff currently holds long positions in companies mentioned above. Read our full disclosure policy here.