Investing would be a pretty easy business if all you had to do was find highly profitable companies and invest in them. Unfortunately it’s not so simple.
The problem with a company making high profits is that they quickly attract competition. Over time, this competition can eat away at market share and erode margins significantly.
Take the fashion industry, for example. Typically, a fashion house will create a new product that gains popularity, like Ugg Boots. Other fashion outlets — particularly discount retailers — will identify the popularity of this product and start to produce their own versions. Not only will these knock-off products eat into the sales of the original, but they will also wear down the exclusivity of the original product as more and more people begin to wear them.
There are some businesses that manage to defy this, however, and can sustain high profits over decades, despite competition. This is because these businesses have an ‘economic moat’ – a competitive advantage that is sustainable over a long period of time.
The concept of an economic moat is crucially important to us long-term investors. Without one, it is practically impossible to forecast earnings over the kind of timelines we are talking about.
You might be able to ‘guestimate’ with reasonable certainty how much money a company will make in the next year, but to estimate for the next ten years is a much bigger challenge. Moats give those profits some form of protection and help us better navigate the future of a company.
Main Types of Economic Moat
- Brand Moats
Moats come in many forms and some are more powerful than others. The most obvious one – the one we as consumers are most familiar with – is a strong brand.
Pat Dorsey, author of ‘The Little Book That Builds Wealth’, argues that effective brands alter consumer behavior because they increase our willingness to pay for something or they lower our search costs.
Tiffany’s (NYSE: TIF) is the perfect example of a brand that increases a consumer’s willingness to pay. For decades, Tiffany’s have charged far more than their competitors for the same product, all because that famous blue box has incredible, intangible value. Similarly, people believe wearing Nike (NYSE: NKE) or Under Armour (NYSE: UA) will improve their performance and so pay a premium on their products. Apple’s (NASDAQ: AAPL) devices are typically much more expensive than competitors’ (and are arguably less advanced), but that doesn’t stop people shelling out big bucks for them.
Brands also lower our search cost. Why would people pay extra for a Starbucks (NASDAQ: SBUX) when they could get cheaper and better coffee elsewhere? Because you know what you’re getting with Starbucks and so you eliminate the risk of being disappointed. You’ll often find people who would never go into a Starbucks or McDonalds (NYSE: MCD) in their local area, but will have no problem doing so when they are traveling.
2. Regulatory Moat
Patents are big in the biotech industry and can create a legal monopoly for a company for 20 years. This means that a company with a popular drug has two decades of unhindered runway ahead of it before the patent expires and the drug becomes generic.
Similarly, some companies have licenses that protect them from competition. Casino operators like Wynn Resorts (NASDAQ: WYNN) benefit massively from the strict licensing laws in territories like Macau, which prevent new competitors coming into the space easily.
3. Cost Advantage Moats
Cost advantages are a form of economic moat that we are seeing more and more of these days with the rise of e-commerce.
Amazon (NASDAQ: AMZN) will always be able to undercut traditional retailers because they don’t have to pay as much for stores or salespeople. In fact, Amazon was originally founded because of a Supreme Court ruling that said businesses only have to pay sales tax in the states in which they have a physical presence. This meant that Bezos could sell books over the internet at a fraction of the prices physical retailers like Barnes and Noble could.
- Switching Cost Moats
Switching costs provide one of the most powerful economic moats because they lock customers in for many years and make it difficult to move to a competitor.
Intuit (NASDAQ: INTU) — the makers of QuickBooks, Quicken and TurboTax — have an incredible moat despite a large number of competitors. This is because they’ve made it difficult to export data from their software to someone else’s. Not only that, it takes time to learn how to use their software effectively and so any business that wants to switch will have to incur additional training costs.
- The ‘Network Effect’
Finally, the ‘Network Effect’ is a type of moat that makes businesses more valuable the more people use them.
The more consumers that have a Mastercard (NYSE: MA) card, the more retailers will accept them. The more retailers accept them, the more people will get one. Creating a cyclical network like this is an incredible advantage for a business that takes a cut out of every transaction that we make.
Similarly, holiday-makers will check out reviews on TripAdvisor (NASDAQ: TRIP) and then add their own, leading more people to visit the site. The more people visit the site, the more advertisers want to be on there.
Taking Advantage of Moats
Investing for the long term requires a long-term outlook on the world and on those businesses that you’re planning to own. Most businesses we will ever encounter will be a flash-in-the-pan success at best, and it is often these hyped up stocks that get early investors in trouble.
In order to be successful investors, we must be able to identify companies that will be able to sustain and thrive in an unforeseeable future.
A narrow economic moat means that a company only has a slim competitive advantage over its industry rivals.
Pricing power means that a company is able to raise the price of its products without seeing a drop in demand for them. Companies with an economic moat typically demonstrate strong pricing power because customers value the service they provide.
Some analysts give companies a score relative to their perceived economic moat. Morningstar, for example, gives publicly-listed companies an economic moat rating based on the five sources of economic moat it has identified: switching cost, network effect, intangible assets, cost advantages, and efficient scale.
MyWallSt operates a full disclosure policy. MyWallSt staff currently hold long positions in companies mentioned above. Read our full disclosure policy here.
Head of Content and Publishing at MyWallSt
James is the Head of Content and Publishing at MyWallSt. James’ favorite stock is Teladoc because he believes that they are at the forefront of revolutionizing the healthcare industry.