Economic Moats

In general there are 5 ways for a company to build a competitive advantage over its peers. Warren Buffet calls this competitive advantage as “economic moat”. An economic moat is the ability of the company to keep its competitors at bay from hurting its profits.

The wider the moat, the longer the company can protect its profits. The deeper the moat, the more profitable is the company.

A company can build its competitive advantage in one or more of the following ways.

1. Product differentiation.
2. Branding.
3. Low costs or prices.
4. Locking in customers.
5. Locking out competitors.

Product Differentiation

A company could produce and market a product with superior technology or features not found among its competitors. And usually these products are introduced to the market at a premium price, which makes the products very profitable. There are customers who will be willing to pay more to get products with the latest technology or best features.

Unfortunately, this type of competitive advantage is usually short-lived. Technology is constantly advancing and today's market leader could become obsolete tomorrow. Competitors are always churning out superior products by adding or improving features. In short, it is difficult to constantly stay one step ahead of the competitors.

Although companies can occasionally generate excess profits by staying one step ahead, these profits are however, not sustainable. We call this competitive advantage a narrow economic moat.

Branding

The advertising industry is a multi-billion dollar industry. Companies spend enormous amount of money to build their brands. The aim is to deliver the message that their products or services are better than the competitors.

A strong brand can be a wide and deep economic moat. Consider designer label apparel and accessories. People are willing to pay much more for the branded apparel than an identical item minus the brand that is selling in the local store.

And as long as people perceive that the items associated with the brand is of superior quality, it doesn't really matter if the product is actually better or not. This fact that people are willing to pay more is what defines the value of the brand. A brand that can significantly increase profit margin is known as a deep economic moat.

Not all strong brands can help boost profitability. Brands are not useful in some industry. Consumers are unlikely to pay much more for a branded computer than a clone computer with the same specifications and features.

Assessing brands this way helps to separate valuable brands and less valuable brands. A brand that lasts for a long time will create a wide economic moat.

Low Costs or Prices

Offering the same or similar product or service at a lower price can be a powerful economic moat, especially in commodity industries. Airlines and PCs are a couple of commodity industries.

Cost advantages are created by either inventing a better process or achieving a larger scale.

Dell is an example how a better process can reduce costs. Dell PCs are built only after purchase orders are received. This way Dell could avoid stocking up on inventory and letting the inventory value erode while waiting for orders to come in.

At the same time, Dell could take advantage of the rapid price decrease of PC components. This allows Dell to do one of 2 things. Keep the selling price the same, thus increasing margin, or lower the selling price as the price of components fall.

Scale advantages are difficult to beat because they build on themselves. Consider Wal-Mart. Its strength is in the sales volume. Manufacturers are desperate to get their products displayed on the shelves. Hence, this gives Wal-Mart the strength to negotiate lower costs from the manufacturers which is then pass on to consumers through lower pricing or better deals. This in turn attracts even more consumers and more sales resulting in stronger negotiation power for Wal-Mart.

Locking In Customers

Companies can deter customers from switching to competitors' products by creating high customer switching costs.

If the customer has to undergo significant amount of training and incur lost productivity during the training period, then the customer will be reluctant to switch.

If a company's product is tightly integrated with the customer's business, then the customer will be reluctant to switch. Example, a customer manufactures food and buys an ingredient, such as a sauce, from a company. Switching supplier and buying the sauce from another company may result in the finished product having a different taste and texture which may negatively affect consumer preference.

Locking Out Competitors

Companies holding patents of popular and lucrative products have deep and wide economic moats. Patents protect the patent holder from direct competition. A great example is Pfizer and its line of top-selling drugs in the world.

Majority of the cities cannot support more than one large daily newspaper. This means the incumbent holds an advantage. It is difficult for a competitor to enter the market and grab a sizable market share from the incumbent and at the same time still make a decent profit.

In summary, when analyzing companies and identifying its economic moats, always put yourself in the customer's shoes and ask yourself questions. ‘What is keeping the competitors at bay”, “Why are the products more expensive than the competitors' products?” When you find the answers to these questions, you will likely have found the company's economic moat.

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