Updated on: August 03, 2020 ; Investments
Why are we talking about moats?
You must be wondering, what have moats got to do with companies and investments. Before we get there, for those who don’t know what moats are – Moat is a canal or a ditch filled with water, surrounding the outer walls of a castle. This acted as a form of protection or defense against enemy attacks in the medieval periods.
Haven’t got your answer yet? So to answer that, we are going to talk about economic moats for a company. These are not actual moats, but metamorphically these are the moats that safeguard a company from the competition and other threats.
In the world of investment, it is nearly impossible to accurately predict the future. Well, isn’t it true for everything? I guess yes, but let’s stick to investments for now.
There are a lot of uncertainties and complex interplaying factors that no one can foresee. Predicting the ripple effect of any change on other factors and their collective impact is even more difficult.
In that case, how would you form your investment strategy? One reliable way is to invest in good companies that can stand the test of times, and have the ability to provide sustained earnings growth. You might not know the exact earnings figures in the future. But if you choose the right company or set of companies, you are sure to earn handsome returns in the long run.
And one crucial aspect of such good companies is having strong moats. Companies with stronger moats have a better chance of surviving and delivering sustainable growth in the future. Having such companies will provide stability to your portfolio and help achieve superior returns.
Why are moats so important?
By now, we understand why moats are so important for a business. Before we talk about the different types of moats, I would like to stress the significance of moats a bit more.
Businesses face many challenges like the constant threat from competition, evolving technologies, changing customer preferences, revised government policies, dynamic geopolitics, and many more. All these factors leave no company invincible. What may look like unbeatable today, may easily crumble tomorrow under unexpected circumstances.
While some of these circumstances would be unforeseen, some would be visible. The least we can do is understand and analyze some of these circumstances or factors. This will help in choosing the right companies for investment and minimize any downside risks.
Just to make this more real, I have listed down some great companies who were leaders in their segments at one point in time. But due to different reasons, they failed at some point in time. Nokia, Kodak, Yahoo, Sears, Blackberry Motion, General Motors, HMT, Hindustan Motors, and Air India are just a few examples.
You might have heard of some of these organizations. They are a testament to the fact that no one is invincible. So, you should be looking for good companies with a wide and deep moat.
Moats provide the companies with a long-lasting competitive advantage and the ability to endure during hard times.
So what are these moats?
A company can have many different types of moats. More the number of moats, the stronger is the position of the company. Please note that just the presence of moats is not sufficient. Moats are just for protection. The company would still need to have a sound business and other key ingredients required for success.
Let’s see what these moats are:
Low-cost: Any company that can produce its products at a lower cost than its competitors, without compromising the quality has an upper hand. This is also applicable to service-related companies. This could be because of access to cheap raw material, lower cost of production, low tax rates, etc.
Low cost means the ability to sell cheaper and outdo the competition. It could also mean higher earnings that the company can use to its advantage in many different ways. The company would still need to produce relevant, good quality products that consumers like and are willing to pay for.
Large market share: It is difficult to replace an existing player. It becomes more difficult if that player enjoys a large market share. This means that it has done something right to be the first choice of its customers. It also has a higher chance of being the first choice of any new customer looking for the products or services that the company has to provide.
Market leaders have many advantages in terms of bargaining power with suppliers. They have more leverage to experiment with new ideas. A few failures are not going to impact them much, but the potential upsides can be huge.
High switching cost: Switching costs mean the cost in terms of money or effort someone has to bear when moving from one company to another. This would be applicable in cases where there is a substantial amount of money and effort spent on buying any product or service.
For example, if you bought a software that your company has been using. You would have incurred the cost of buying the software first. Then you would have invested time and money in integrating it with other systems. There would have been some cost incurred in training your employees to use the software. So if you plan to switch to a new software tomorrow, You will have to spend again on acquisition, integration, and training.
It is equally true for any hardware or machinery you would have bought for your company. Switching over to a new company would be a very costly affair. High switching cost reduces the chances of losing existing customers to the competition.
Network effect: This is a phenomenon where a higher number of customers or users for a company makes the company’s position stronger. This is mostly applicable to internet companies. Take the example of social network sites or messaging apps. Suppose you are not on any social network or messaging app and want to join one now. Which one would you choose?
You would most likely join the one that has more number of people you know, on it already. This is the network effect. Consider platforms that have already built a strong base of users and are providing good services. They would continue to grow as long as these services are relevant, and the network is vast. Would you join a social network that has some cool features, but very few of your friends are using it?
The network effect grows stronger with the addition of each user. Success fuels further success. Some examples are Airbnb, Uber, Facebook, etc.
Brand value and trust: It takes ages to build trust and brand value. Once a brand is established in the market, people would be ready to pay a premium for the brand, as it ensures quality and consistency. It becomes easier for the company to increase its sales and expand into new territories.
Once people are attached to a brand, they start associating with them after a point in time. The competition starts to become invisible or irrelevant to some of them. Brand loyalists are also great promoters for the company’s services and products.
It is not easy to maintain brand value over time. Companies have to make a consistent effort to maintain the standards otherwise, they may lose the edge.
Unique product/Innovation: Now this one is easy. Any company with a unique product or service that has a market is a clear winner. There is a minimal threat from competition. Customers will have no choice but to come to the company for its products or services.
But the competition would be watching, and they would soon come up with a substitute or a better version. So the key to staying ahead is to constantly keep innovating. Companies that spend dedicated money and effort on research and development, and are connected to the market realities have an advantage here.
Regulations and natural advantage: These factors are not in the control of a company. They are based more on the luck of the company. Certain regulations favor an industry or a company. This could be in terms of restrictions on new entrants, tax benefits, special permissions for business, long term government contracts, etc.
Next, there are companies that own scare natural resources or have special access privileges. These are advantages that can not be taken away or replicated by a competition easily. These factors provide an unassailable advantage to any company.
The shortcoming of this advantage is that many companies that have it can often become complacent and ignore innovation.
IP rights: Intellectual Property rights are closely linked to innovation. It is similar to the point of the unique product and service discussed above. A company can enjoy the fruits of its innovation in terms of royalty or exclusive access to certain markets. Again, they have to spend consistent effort on innovation and stay ahead of others.
Conclusion
We talked about different types of moats that are advantageous for companies. So look for companies that have these moats. A company doesn’t need to have all of these moats. You can find companies that have two or three great moats. Good businesses with wide and deep moats should be good candidates for your investment.
Happy moat fishing!!!