Quantitative Value

“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.

Industry Without an Economic Moat

You will often find firms with economic moats to be extremely profitable in the long run – provided that their competitive advantage is maintained.

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!