Moats: What are they and why should I care?

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It is often said, investors should look for companies with moats. Now everyone knows what a moat is literally, but outside of European castles and celebrities homes in LA, it’s tough to find a moat these days.

So what do we mean when we talk about a moat in an investing context?

It was a term popularised by Warren Buffett, and in the same way that moats protected medieval castle from invaders, economic moats are features of businesses that protect them from their competition. Here at Equity Mates we want to help you conceptualise what these different moats may look like.

Importantly, we’re listing 5 here but this is just our way of categorising them. Other people will give you different categories. The important thing is to find a framework that you understand, and that helps you find these businesses that are protected from their competition.

So without further ado:

  1. Cost Advantage

A cost advantage is when a company can produce a product significantly cheaper than their competitors. This might be because they have a new technology, or simply because they enjoy the benefits of scale.

A good example of a company with a cost advantage is Wal-Mart. Wal-Mart operates at such a large scale that it can offer goods at a significantly cheaper price that their competitors. Alternatively, in the 1970s Toyota took the global car market by storm because their lean manufacturing process gave them a significant cost advantage. This allowed them to offer a quality car at a lower cost than any of their rivals could match.

Often you see companies with a cost advantage drop prices to try and drive out a new competitor that cannot offer the goods or services as cheaply. Think airlines or supermarkets dropping prices to beat their competition.

When thinking about cost advantage the most important questions is, is it durable? The examples of Toyota and Wal-Mart show that it is rarely the case. Wal-Mart is now facing price challenges from Amazon and Costco, while Toyota’s manufacturing methods have been studied and emulated across the world. So as an investor you have to look for companies that are using their cost advantage to its utmost potential while they still have it.

  1. Network Effect

A network effect occurs when all users of a good or service benefit from every additional user. Companies that can begin to build their network develop a moat, as any rival company does not have the network that attracts users.

The best example of this is social media. Facebook enjoys a network effect as each additional user benefits all other users. Facebook is a lot more valuable to you with all your friends using it than if it was just you. Similarly, if MySpace tried to make a comeback they would struggle to attract new users because everyone is on Facebook.

Another company that enjoys a network effect is Microsoft. Microsoft Office products are the standard for businesses and schools across the globe and this gives them an incredibly strong moat. A rival software company may come out with a better word processor, but it’s no good to you if no-one can read the documents you send them because they don’t have the software as well.

It’s incredibly hard to break this network effect. Just imagine trying to convince the company you work for to stop using Microsoft Office.

  1. Intangible

The most common intangible is a company’s brand. A brand can convey trust or status or meaning, but be warned you’ll need your bulls@!# meter up when analysing this. Every company will claim they have a strong brand and even if that is true a strong brand isn’t enough to be a moat.

For a strong brand to equal a moat it must convey something that will stop a customer using a competitor.

For example, Rolex and Tiffany convey status and prestige. A customer may be able to buy a cheaper watch or piece of jewellery but they choose these brands because of the power of the brand. As well as status a moat can be generated by brands that are trusted by consumers. For example, Australian infant formula companies like A2 Milk and Bellamy’s are trusted to be clean and safe by Chinese consumers – giving these companies strong pricing power.

The important question to ask is, does this company’s brand mean its customers will stay with it, even if prices rise significantly? If you answer yes to that question, then it is likely you’ve found a company with a strong moat.

  1. Switching Costs

Switching costs can be an incredibly strong moat, but be warned they can also stop customers coming back to your company if switching costs are standard across the industry.

The best example of switching costs is with Telecommunication companies. Ever grown dissatisfied with your phone plan and tried to switch? Well first thing you have to do is pay out your plan. That cost of switching stops a lot of consumers moving to a different company, even if they’re unhappy with their current provider.

Switching costs don’t always have to be about money. They can be time or effort based as well. An example of this would be Apple. Customers that have only ever used an Apple computer or phone may choose to stay with Apple because of the effort it takes to get used to a new operating system and new software.

  1. Legal monopoly

A final moat you could look for is a legal monopoly. This is where the government regulates the industry to stop competitors entering that industry. There are a variety of reasons a government might regulate an industry in this way, but the result is protection from competition for the company.

This mainly takes the form of intellectual property protection. These are patents, trademarks and copyright that legally stop competitors from directly competing with the protected companies. For example, pharmaceutical companies get patents on new drugs that stop competitors making the same drugs for a set period of time. Copyright protection gives companies such as Disney protection from other companies using their ideas or characters in their own productions.

Another form of legal moat is government regulated monopolies. These occur when the government creates laws or regulations that allow only one company to provide goods or services in a particular area. One example of this is Port operators. Governments will tender out the operation of a Port and once they decide on a successful tender, that company will not be subject to any competition in the running of the port. As an example, a European listed company – DP World – operates the Port of Melbourne.

Okay, so you’ve found a moat?

Just because you’ve found a company with a moat, it doesn’t mean you should automatically invest. You want to find companies that are using that moat to grow their business.

There are plenty of examples of companies that have let a moat go to waste. Two recent examples would be Yelp and Trip Advisor. Trip Advisor has an excellent network effect – as more users rate different attractions, restaurants and hotels, this adds value for every other user. Yet its performance as a company has been less than stellar despite the strong network it has built up.

So that’s why moats are only part of the search for a great investment. But when you find one, you can buy and hold it for years as it grows and grows, protected from competitors by its moat.

Comments

    1. Author

      Thanks for your feedback Craig. We’re hoping to be able to get more content like this out to you guys in the new year! Cheers, Bryce

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