Investing with an Economic Moat: Protecting Your Portfolio for the Long Term
Investing would be a straightforward business if all you had to do was find highly profitable companies and invest in them. Unfortunately, it's not so simple.
The challenge with a company making high profits is that they quickly attract competition. Over time, this competition can eat away at market share and significantly erode margins.
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.
However, some businesses manage to defy this trend and 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.
Understanding the Economic Moat
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 estimate with reasonable certainty how much money a company will make in the next year, but to forecast for the next ten years is a much bigger challenge. Economic moats give those profits some form of protection and help us better navigate the future of a company.
Main Types of Economic Moats
- 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 a perfect example of a brand that increases a consumer's willingness to pay. For decades, Tiffany's has charged far more than its 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 for 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 from 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, eliminating 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.
- Regulatory Moats
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 from entering the space easily.
- 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, but it also takes time to learn how to use their software effectively, 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 economic 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 Economic 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.
Quickfire Round
What is a narrow economic moat?
A narrow economic moat means that a company only has a slim competitive advantage over its industry rivals.
Why is pricing power so important for companies with an economic moat?
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.
What is an economic moat rating?
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.
