The Beginner’s Guide to Understanding Economic Moats
by: Tam Ging Wien
author of REITs to Riches: Everything You Need to Know About Investing Profitably in REITs
This article was first published on ProButterfly.com on 01-May-2018.
We decided contribute to the InvestingNote community with an educational piece to help investors identify if the company that they are investing in possesses 1 or more of the 5 key economic moats.
The term economic moat was coined by Warren Buffet to describe the sustainable competitive advantages which a business is able to maintain over its competitors. Economic moats are usually difficult to copy or emulate which creates a strong competition barrier preventing other businesses from capturing its market share and eroding their profits. We can visually imagine a business like a medieval castle protected by deep and broad water defenses. The wider the moat, the more difficult it is to attack the castle.
When investing in businesses, we want to ensure that these businesses have one of more of the following moats in order to ensure that it continues to sustain its competitive advantage.
The 5 Economic Moats
Monopoly / Oligopoly
An industry that is monopolized by one or oligopolised by a very small number business are have a strong moat as it would be very difficult for a competitor to enter the market. A monopoly could be a result of government policy or regulation that is sanctioned by the state. The government may choose to reserve the venture for itself or issue a license only to 1 or a small controlled group of businesses.
An example of a monopoly is Genting Malaysia which is the only business legally licensed to operate a casino in Malaysia. It does not need to be concern with business strategies to deal with competitors, instead it is better able to focus its resources on marketing efforts to draw great visitorship and patrons to its casino.
Economies of Scale
Some businesses have grown very large and are able to control the entire industry supply chain from producer to retail. Due to their large size and high volume, they are also able to keep their unit cost low in order to command a higher margin or offer the same product at a lower price compared to their competitor. This becomes cost prohibitive for new competition to compete in the same markets due to excessive investment cost in order to be able to gain the same marginal benefit. These new competition also face the possibility of these giants undercutting their prices owning to thicker margins.
Jardine Cycle & Carriage for example derives majority of its revenue from a subsidiary called Astra International whose core business is to distribute vehicles in Indonesia. Due to Astra’s huge distribution network, strong partnership with brand owners and exclusive distribution rights for established brands such as Toyota, Daihatsu, Isuzu, BMW and Peugeot in Indonesia, it is able to command a wide moat discouraging new competitions in Indonesia.
High Switching Cost
For some businesses, their products are incredibility expensive, troublesome or inconvenient to stop using. The business and product is intentionally designed to make switching to a competitor’s product challenging. This creates a natural deterrent for a customer to stay with the business and continue to pay subscription fees to the business for the use of their products. The clients are also at the mercy of the business as it can freely set prices knowing that their clients are unlikely to switch. These businesses also can easily pass on their cost to their customers to maintain their margins.
High switching cost is also a double edged sword which cut both ways. If a business has a product which has a high switching cost, it has very long sales cycles as its potential customers will take a longer time to come to a decision to regarding adopting the product.
Taking Silverlake Axis as an example, it is in the business of providing the core banking platform for 2 out of 3 of Singapore’s local banks. Core banking software is central to a bank’s business and once in-place, the bank would find it highly inconvenient to change to another core banking platform. Doing so would run the risk of disrupting business operations, migrating and protecting client’s data, many years and millions of hours of planning and execution, countless hours of retraining staff on the new platform and finally an unknown risk of implementation failure. This high switching cost deters existing customers from switching out of Silverlake’s platform, as a result Silverlake is able to continuously maintain highly profitable software license margins.
A network effect occurs when a product or service increases in value as more customers come on-board. Similar to the English language, due to a large proportion of the population that speak the language, more people also want to learn to converse in English leading to its dominant position as the lingua franca in global trade. Businesses which established the network effect early on in their business tend to be trend setters and market leaders who benefited from the first mover advantage. The effect powerful and creates a very wide moat as the cycle is self-perpetuating.
A good example is Facebook which already has a large user base. As all our friends and family are using it to maintain contact, bridge communications and share social lives, we will also naturally gravitate towards using Facebook as our choice of online social platform. Facebook also has a number of products such as WhatsApp and Instagram which also processes this network effect resulting in growing customer base.
A business may have over the course of its operations acquired strong intellectual property (eg patents, trademarks, copyrights), developed strong and recognized brand, received regulatory approval or permits or have a special geographic advantage due to its location. These various possessions while may not be physical, is able to allow the business to charge a significant price premium. Patents and copyrights prevent a competitor from replicating its core product; businesses with strong branding naturally lends creditability, association and trust in their products. Risk of business disruption is present if its patents expire, reputation erodes, licenses revoked, patents, expire or infringement lawsuits.
One example is Sarine Technologies, a company headquarter’s in Isreal but listed in Singapore offering precision products to aid in the processing, polishing and trade in diamonds. Sarine have proprietary technologies protected by patents can cannot easily be replicated by a competitor.