Why is having a moat important?

Companies are born with the potential to be great. In the end, defensibility is what will define the success of the business and make it attractive. Though, many investors are easily misled into focusing only on the rate of growth instead of trying to evaluate whether the business can earn excess returns in the long run – the longevity of profitable growth.

The best businesses are protected by some sort of durable competitive advantage, also called competitive moats. Competitive moats are a business’s capacity to maintain competitive advantages that preserve its long-term profitability and market share in the face of competition. Companies with competitive moats typically survive financially even if management talent does not deliver as expected or if they leave the business. Such companies can charge much more for their products than it costs to produce them, and can do it for many, many years. They do something special that is not easily replicable by competitors, as competitors eventually erode such advantages. In other words, all competitive advantages, moats or not, eventually disappear over time.

Competitive moats are typically other than expensive capital, superior technology, strategic partnerships, specialised knowledge required to start up a similar business or being the first to start doing business in a new market, as they all tend to be temporary. Such advantages can begin to look like monopolies and yield huge short-term profits before the competition has caught up. Similarly, higher profitability that comes from operational excellence will not lead to sustainable value creation without durable competitive advantages.

This quote from Professor Bruce Greenwald, one of the leading authorities on value investing, serves as a fitting conclusion to this section: “No matter how complex and unique a product seems at the start, in the long run they are all toasters.” In other words, all competitive advantages, moats or not, eventually disappear over time.

What qualifies as a moat?

Finding companies with genuine moats is not easy. It takes time and research. However, extensive literature has emerged since Warren Buffett first introduced the concept in 1999. A company that has generated capital higher than its cost of capital for many years probably has a moat, especially if its returns on capital have been rising or are fairly stable. However, this is the topic of the next article on moats, Competitive Moats – Part 2.

We think for any investor, a solid fundamental framework in competitive moat analysis is simply par for the course. Investors can go wrong in a great many ways, but there’s only an upside to learning the ins and outs of what separates the best companies from the worst ones.

At Redeye we divide all moats on the basis of price or cost advantages – the two main factors that define a company’s profitability. A competitive strategy analysis focuses on identifying these sources of advantage and assessing their durability. Below nine common competitive moats are described briefly:

Cost advantages

Companies that enjoy cost structure advantages produce better quality at a lower price than the competition or just apply price pressure to knock them out. This involves creating a product much cheaper, both to produce and deliver.

Scale Economies

Generate economies of scale in production (buying power) as per-unit costs fall with increasing output, creating a ‘flywheel’ that accelerates as the business grows. In other words, scale fixed costs over larger product volumes, spread them across more product categories or stores, and find new revenue streams to lower the burden of fixed costs. For any company in a capital-intensive business, success depends on implementing these strategies.

For example, building a production plant costs the same regardless of the number of units it produces. Relative size matters more than absolute size as it makes the cost of gaining share prohibitive. Even so, economies of scale tend to dissipate when the market gets large enough.

Scope economies

Gain advantage through new initiatives where the product is interrelated with existing business lines so that they reinforce each other. A company that benefits from economies of scope has a lower average cost because it can leverage know-how and resources from the existing business. In contrast, economies of scale focus on the cost advantage that arises when there is a higher level of production for one single product.

For example, if a company has a strong distribution network that reaches its customers effectively and efficiently, it has a huge advantage over competitors that lack such a network. A company with a strong distribution network will also be able to enter new areas to expand its total addressable market (TAM) as its competitive advantage does not depend on a specific product, but rather its ability to distribute any relevant product. Such companies typically leverage this moat by distributing acquired products to a wider audience than the originator companies could access themselves.

Peter Thiel puts this point well in his great book Zero to One: “Superior sales and distribution by itself can create a monopoly, even with no product differentiation. The converse is not true.”

Efficient scale

When a company serves a limited market effectively, new competitors have no incentive to enter. Entry into a mature, small niche market (in terms of geography or product) is very difficult because niche markets have a high minimum efficient production scale relative to TAM. This implies that a large market share will be needed to cover fixed costs, which may not be justified by the limited profit potential a new competitor might achieve. This natural monopoly-like situation can be even more challenging for a new competitor if it’s difficult to grow the TAM and if there are switching costs involved. In other words, effectively served niche markets are easier to defend than the average profit pool.

Companies that benefit from efficient scale operate in markets that only support one or a few competitors. Greater competitive pressure can easily cause returns for all players to fall to a level in line with or below the cost of capital.

In markets with little change in players’ share, it might take many years (or even decades) for a new competitor to capture a profitable market share, which creates a very high entry barrier. However, beware of irrational competitors entering and causing a change from price-over-volume strategy to a volume-over-price.

Mixed cost and price advantages

Companies that boast pricing power and/or benefit from cost advantages that rivals cannot match.

Monopolised assets

Benefit from entry barriers that represent a critical infrastructure asset with no alternatives or assets protected by law from new competitors. Monopolised assets are resources that competitors cannot access or match without suffering a net economic loss and which act like natural or legal monopolies or oligopolies. This often comes from having developed an expensive asset in the first place and then gaining ownership of it, or geographical dominance by close proximity – making it incredibly difficult for new entrants to replicate. The latter is often the case when the cost of transporting a product is high relative to the value of the product (e.g., cement or mining). Other common avenues of monopolised assets are real estate, railroads, airports, regulatory licenses, government approvals, and patent awards for research developments.

Think of toll roads and casinos, whose existence depends on legislation or regulation and whose protection from additional competition hails from the same source. However, regulations often push returns on invested capital to a level only modestly above capital costs, making them less attractive.

Note: Monopolised assets and brand loyalty are often lumped together into intangible assets, but there are distinct differences between them. For example, brand loyalty is an internal advantage, isn’t cheap to maintain, and its value goes beyond the product’s objective attributes.

Culture power

A virtuous corporate culture empowers employees to perform their day-to-day tasks slightly better than their competitors. Over time, these minor advantages add up to much more significant benefits that can last longer than conventional wisdom predicts. In short, culture lives in the way things get done, is learned by osmosis, and feels natural to employees, but often looks like magic to outsiders, as it allows the company to accomplish a lot more with less.

What makes for culture power specifically varies by industry. For example, a virtuous culture in a technology company may be one that’s obsessed with innovation. But there are some common attributes – Daniel Coyle provides a nice summary in his fantastic book The Culture Code:

• Build Safety: A sense of belonging and identity.
• Share Vulnerability: Confidence to admit mistakes, accept feedback and ask for help.
• Establish Purpose: Narratives create shared goals and values.

It may seem very difficult to evaluate these attributes, but they are all covered as part of Redeye’s Fundamental Rating checklist. There is a high likelihood that the company has culture power if it generates high returns on capital and you can answer all the following seven checklist questions with a ‘Yes’:

1. Does the CEO have a visionary attitude towards the business?
2. Is the business managed in a decentralised way?
3. Does management own its mistakes?
4. Does the CEO uphold company values and link them to its success?
5. Is management incentivised to create long-term shareholder value?
6. Does the company have purpose-driven leadership?
7. Do employees enjoy working for the company?

Finally, culture power has a strong multiplier effect when combined with other competitive moats. It is no surprise that many of the most successful companies are still founder-led, as these typically benefit from an unusual intensity of purpose and vibrant culture.

Counter-positioning

A challenger adopts a new, superior business model that incumbents don’t mimic due to the anticipated cannibalisation of their existing line of business. The incumbent also lacks the domain expertise necessary to be successful in the new business model. This often makes the incumbent delay adoption of the challenger’s business model until the point at which the core business has shrunk enough that adopting it no longer results in a negative economic outcome: by then it’s often far too late.

Counter-positioning is a non-exclusive advantage, which means that any competitor can pursue the new business model. In fact, there are often many challengers counter-positioned to the incumbent. Counter-positioning tends to come from outsiders and start-ups rather than existing market leaders, as it is an attack on the incumbent’s product in a new way that delivers more value to the customer. The new business model is simply superior to the incumbent’s model due to lower costs and/or improved features.

For example, Google introduced Google G-Suite in 2007 with a word processor, spreadsheet, presentation tool, and all the rest to compete against Microsoft Office. It had two big advantages – it was online, so collaboration was easy, and it was also free. It took many years for Microsoft to be able to respond effectively to the threat and, subsequently, Google’s market share went from 0% to 60%, far overtaking MS Office in the process.

At the heart of counter-positioning lies the development of a new business model that, over time, has the potential to supplant the old. In the more general sense of the word, it is disruptive. Counter-positioning was popularised in a book called 7 Powers by Hamilton Helmer, which I recommend highly.

Price advantages

Companies that enjoy price advantages lock out competitors through high entry and scalability barriers to sustainably earn high profit margins. This involves creating a product that is convenient, emotionally appealing, and very easy to use – or simply high quality.

Switching costs

Make it cost more for customers to switch to an alternative supplier than to remain. Switching costs come in many forms, such as money, time, risk, and inconvenience. Breaking good business relationships is an example.

However, switching costs only block customers from leaving rather than attracting them in the first place. It’s therefore not possible to enjoy high switching costs unless the company has a strong value proposition that attracts customers in the first place or it is the first-mover and scales fast to capture a large and profitable market share. In the end, customers hate to change once they are used to and comfortable with a product.

In other words, for switching costs to be effective, the company needs a way to attract customers other than just lowering prices (unless the company is the lowest cost supplier in the market). Still, the value of switching costs can only be captured if a buyer purchases repeatedly or buys add-on products.

Deeply customised or integrated products supporting mission-critical applications create high switching costs. For example, if the product is embedded in the customer’s workflow in a way that makes it prohibitive for them to switch, this leads to relatively insurmountable switching costs (including all forms mentioned above, money, time, risk, and inconvenience) – particularly when combined with very long product life cycles associated with inability to exit from the initial investment. A similar situation arises when the product involves customers having to climb a steep and lengthy learning curve. In such cases, if the supplier can generate substantial aftermarket revenues, it will have endowed itself with a substantial competitive advantage.

Common examples are utility suppliers (gas, electricity, internet, phone, etc.), computer operating systems (it’s much easier to stay with Windows, Apple, or Android than it is to switch between them), enterprise software (where staff are used to using the current system, have entered large volumes of data into it and have integrated it with other software systems).

However, a virtuous cycle tends to develop in high-tech industries where switching costs are high: the company with the most customers can invest the most in research, which leads to more advanced products, and this, in turn, attracts more customers, in addition to those already bolted-on. Things tend to snowball.

Network effects

Provide a product where every new user makes the product more valuable to all other users. This is like scale economies, but instead of reducing the producer’s cost it increases the buyer’s willingness to pay. To be able to scale fast it’s critical to get the product right early on, as networks win only at scale.

A successful network requires both a product and its network. For example, in a two-sided network like an auction or a marketplace business (product), more buyers showing up will attract more sellers – which will attract more buyers in turn (network). Once this positive cycle is in place, it becomes nearly impossible to convince either buyer or seller to leave and join a new platform. Businesses such as eBay and Airbnb have built up strong two-sided networks over time.

The key to success is to start by building a single small network that’s self-sustaining on its own before it is ready to scale, rather than a grand launch that risks creating several weak networks that aren’t stable on their own. This is done by first capturing the ‘hard side’ of the network, the small percentage of content creators who capture most of the engagement.

However, when large networks reach very substantial scale they tend to involve many diverse communities, where the most underserved are the ones most vulnerable to new niche competitors. It will often take an all-out effort for the larger networked product to compete against this type of smaller niche player, even though they often lose in the end.

Networks can also become overcrowded. An example is when a communication product starts sending too many irrelevant messages or a social product fills up with irrelevant content or a marketplace sees too many listings. Without strong curation mechanisms in place, this can lead to a network collapse.

Different types of network effects are stronger or weaker than others, and they each work differently – learn more about them at www.nfx.com (http://www.nfx.com/). You can also read the exceptional book The Cold Start Problem by Andrew Chen to develop your understanding of the power of network effects and how they work.

Brand loyalty

Create a strong brand that will earn superior returns to those with no branding. A strong brand means consistency and a promise to consumers, who will prefer it over any other, almost regardless of price or convenience and sometimes even if the product is substandard. Loyal customers are simply less tempted by other offers and incentives since it is the label, not the product, that bestows brand loyalty..

Brands can create customer loyalty through one or both of these two routes:

• Reducing uncertainty as the customer attains ‘peace of mind’, knowing that the product will be as just as expected. This happens through (a) lower search costs as an informational advantage of being well-known and/or (b) good reputation to confer legitimacy.
• Eliciting good feelings about the product, distinct from the objective value. This happens when it signals status to express individuality.

Different brands have created associations to different customer emotions. The stronger the emotion, the stronger the customer’s affinity to the company. However, creating a strong brand takes a long investment runway with no assurance of success.

Moreover, brand loyalty to a company typically grows stronger over time because consumers judge a brand’s virtue partly by how long it has been consistent. Yet counterfeiters with inconsistent offerings may undermine it. Efforts to copy another brand run the risk of trademark infringement actions with their related costs and uncertain outcomes. Finally, branding is a non-exclusive advantage, which means that a competitor can target the same customers with an equally impactful brand (Prada, Louis Vuitton and Hermès, for example).

One caveat to brand loyalty is that the internet has changed how brands are developed and made loyalty harder for less authentic brands to sustain. Global brands that once won consumer mindshare (i.e., brand recognition) by having the biggest advertising budget now face upstart brands with vibrant low-cost social media followings. We have entered a time of retail meritocracy where consumers are more willing to compare, and everything is always on the record.

Placement and brand may not be as important in the Internet’s infinite mall with unlimited shelf space and near-zero cost of distribution. This is particularly devastating for brands built around consumer ignorance, like those that aren’t highly valued by their customers and only reduce search and discovery costs – brands with a weak value proposition. Hence, when assessing brand loyalty, always ask yourself if customers would choose this company’s product if they were well-informed and had access to their competitor’s products?

For example, Luxottica has had a dominant position in the old world distribution and marketing platform of sunglasses and eyewear. In this model, floor space and commercials served as a solid barrier to entry. But there’s been a trend towards commoditisation of sunglasses and eyewear as consumers become more comfortable with buying off-brand names like Warby Parker. Online reviews, ratings, etc. have weakened Luxottica’s competitive moat.

Selected books and sources

Below you can find our recommended sources of timeless insights to expand your knowledge about moats and investing.

• Michael E. Porter – Competitive Advantage and Competitive Strategy
• Bruce Greenwald – Competition Demystified
• Michael J. Mauboussin – Measuring the Moat (listen to our podcast episode with Michael Mauboussin (https://www.redeye.se/podcast/investing-by-the-books/827962/10-michael-mauboussin-expectations-investing)).
• Pat Dorsey’s two books – The Little Book That Builds Wealth and The Five Rules for Successful Stock Investing are two fine pieces of literature on the topic 
• Heather Brilliant – Why Moats Matter dives deep into what the firm believes are the five sources of an economic moat: intangibles, cost advantage, switching costs, network effect, and efficient scale. (listen to our podcast episode with the author Heather Brilliant (https://www.redeye.se/podcast/investing-by-the-books/820984/5-brilliant-mohanraj-moats-matter)).
• Hamilton Helmer – 7 Powers: The Foundations of Business Strategy

This is a developing article, please check back for updates.