While it is romantic to think about a small company started in someone's garage growing into a power house, that is usually not the outcome. However, there are enough exceptions to keep investors interested - think Microsoft and Apple.
Many investors are uncomfortable with the inherent risks associated with investing in small companies and opt for giants instead. One of the common factors these giants share is a competitive advantage or economic moat that makes it challenging for competitors to take market share.
Economic moats are competitive structures that help great companies continue to be great investments. Stock in a company with a substantial economic moat is usually much safer than investing in companies that have strong competitors.
The term "moat" refers to one or more advantages a company has over its competitors.
In most cases, it is management that builds the moat. It is rare that a company has a sustainable moat by virtue of its industry alone.
A market truth is that capital always seeks earnings and any company that is creating substantial and ongoing wealth for its investors will draw competitors.
Having a strong moat is no guarantee of success, but it does suggest that it will be difficult to displace it as a market leader or money maker.
What is a Moat
Investors have different ideas of what a strong moat should look like, but there some general guidelines to consider:
- Offering lower costs. This is the most tenuous of the moat because it leaves the door open for competitors to match prices. However, when combined with size, it's a hard moat to breach. Wal-Mart is the obvious example of this type of moat, where the company uses its size to bargain (or force in some cases) price concessions from vendors that other retailers can't match. This strategy is only successful if the company can absolutely control its other costs and drive more volume than competitors.
- Making it difficult for customers to leave. Companies that lock in customers through the cost or inconvenience of leaving have a moat of value. Often customers are locked in for because it would take time to switch. For example, if you are a heavy user of electronic bill paying or other online financial services, it is often time consuming to switch financial institutions. Another example, is a product that has a steep learning curve. If customers master one product or service, they will be reluctant to choose a competing product or service.
- Holding competitors at bay. One way to build a moat is to put roadblocks up that make it difficult or expensive for competitors to enter your market. When governments regulate certain markets, it can be a barrier to competitors - casinos, for example. Another barrier is patents that prevent, at least for a period of time, competitors from grabbing market share. Drug companies are a good example of this type of moat. A blockbuster new drug can generate tremendous profits before generic versions are available.
- Superior products. Having the best of class can be a significant economic moat, although it is sometimes narrowed to niche markets. The products don't have to be the best, but if they are perceived to be the best or at least industry standard, that works too. Years ago, when IBM owned the main-frame computer market, there was a saying in IT departments that, "nobody got fired for recommending IBM." Whether IBM made the best computers was not relevant. They owned the business and nobody could be faulted for recommending the industry leader. The same could be said for Apple today.
Economic moats are powerful and valuable assets to companies and worth a lot when evaluating a company.
However, like all measures, you shouldn't buy a stock just on the width of its economic moat. Things change and moats have a habit of drying up if companies don't diligently manage them. Also, the stock of companies with strong economic moats may be priced at a premium.
Still, a company with no economic moat will have a difficult time in today's competitive environment.