“In business, I look for economic castles protected by unbreachable ‘moats’.” – Warren Buffett
The best kinds of businesses that I love are the ones with strong economic moats. They are often characterized by supernormal profits and high returns on capital. In this post, I characterize the different economic moats that exist.
Companies with profitable margins are often eroded over time. The bubble tea craze a few year back is a textbook case. Initial start-ups were immensely profitable and its novelty soon became a craze. Competitors soon entered the market and before long, the once profitable industry became over-saturated and profits plummeted.The bubble tea industry is one in which firms possess virtually no economic moat at all. Coupled with the fact that entering the industry was relatively low, pioneers of bubble tea were soon unable to maintain past profit margins.
You will often find firms with economic moats to be extremely profitable in the long run – provided that their competitive advantage is maintained.
Type of Moat | Examples |
Intangible Assets | Tiffanys & Company, Nike, Coke |
Customer Switching Costs | Adobe. Microsoft |
Network Effect | Microsoft, Visa, eBay |
Cost Advantages | Dell |
Intangible Assets – Brands, patent and regulatory licences. Patents of drugs drives profits from pharmaceutical companies – one reason why they are so highly guarded. Strong brand names such as Nike or Tiffanys & Co. allow companies to charge much higher premiums as compared to their competitors. If consumers are willing to pay a premium for a brand name – you have evidence of a moat.
Customer Switching Costs – Adobe has come to become the gold standard for image editing software. Most designing firms run using its propriety software not because it’ cheap but because were trained using Adobe Photoshop. Switching to cheaper software doesn’t make sense as any savings made will most likely be offset by the loss of productivity (not to mention the risk involved).
Network Effect- Credit card companies are a prime example of this economic moat. You’ll find that shops readily accept cards like AMEX or VISA. Competitors who try to enter the market will be hard pressed to competing against well established networks.
Cost Advantages – Dell, famous for their optimizing and reducing cost in the process flow has done exceedingly well compared to its competitors. By cutting out the middle-man and selling directly to consumers, they have a comparative advantage against well established players like HP.
This list is by no means exhaustive but merely acts as a good reference point.
I recommend reading “The Five Rules for Successful Stock Investing” as a great primer for learning more about economic moats in different industries. I also recommend “The Little Book That Builds Wealth” as a secondary reading.
I will be covering economic moats of locally listed companies in my next post. Look out for it!
Hey Juno,
How true, what is sometimes “bad” in the interests of consumers are actually good for the businesses themselves.
Look forward to your coverage of the local companies!
Cheers,
Royston
Thanks for visting!
I am glad you enjoyed it 🙂
Will post up my article once I have time to finish it.
Yours Sincerely,
Juno.tay
The question is, how can a company selling caramelised water (coke) have a strong intangible moat but companies selling bubble tea have no moat at all?
How can you tell what a company’s moat is about to be overrun (i.e. Yahoo) so you can get out in time?
Are Apple & Google companies with strong moats or just in the right place at the right time, right now?
The problem with identifying the moat after it has been proven is that the market will have already priced it in, so unless your investment strategy is based on dividends you won’t be making much in the way of returns.
Hi milodino. Like you said there is no sure way to tell when a moat is about to be eroded. I normally classify moats as either being Wide or Narrow Moats.
I believe that there are a number of reasons as to why some companies have a moat and others don’t (circumstance being one of the most important imho). Better advertising, being the first, better management are some but you get the gist.
I find Moats to be especially narrow for the technological sector (i.e. I have no idea whether Apple & Google will be still leaders of their field in 10 Years.)
However certain kinds of companies (imho at any rate) are easier to predict. I don’t see taste preferences companies like MacDonalds & Coke drastically altering any time soon (I could be wrong though..). Its really a matter of investing in your circle of competence.
To answer your final question, I do agree that companies with great moats are normally fully valued (or even overvalued). However, markets as I am sure you know are wildly irrational sometimes. Bad news can send the stock plunging making it a fair buy (2008 – 2009 comes to mind). Its really a judgement call, deciding whether any sudden, substantial price drop is a result of over-reaction or a real loss of competitive advantage in the company.