Setting the context: In this article, let’s understand the term “Economic Moat”, what it entails and how we can identify one.
What is an Economic Moat?
This term was popularised by Warren Buffet. An Economic Moat is a company which can retain a competitive advantage over its peers in the long run and thus protect its long-term profitability and market share. So, why is this important? When a company establishes it’s brand value, has a superior competitive advantage over other players in the market, then competitors can’t erode away it’s earnings that easy, creating a beautiful recipe for a valuable company to identify and invest in for the long-run.
Types of Economic Moats
(I) The Network Effect: A company, a product or a service whose value increases for both the existing users and the new users, as more people use it, is what the Network Effect is all about.
Explainer: Suppose, Facebook, was actively used only by a small college community in Boston (which is how it all started, but it scaled exponentially), the site would have been less appealing now for someone in their 50s from Australia or Africa seeking to converse and socialise with someone from his/her own age group and proclivities. The more people join Facebook, the more valuable it becomes for both the existing users and for the new users joining it. This very fact makes Facebook all the more powerful. If a newbie platform, joins the social media market with much better UI and functionalities compared to Facebook, there’s still a large innate competitive advantage on Facebook’s side, the “Network Effect”.
(II) Intangible Assets: Certain companies differentiate themselves in the market because of some non-physical asset, these type of assets are called intangibles. Examples of intangibles are things like patents, government approvals, trademarks, copyrights, brand names, human capital or a unique company culture (For example: Ray Dalio’s emphasis on Idea Meritocracy in Bridgewater Associates).
(III) Economies of Scale and Low Cost Offering: Companies can have a competitive edge attributed to economies-of-scale. Wherein they can deliver goods and services at a far cheaper cost as the amount of production increases. These companies have a unique advantage since they can drive their competitors out of the scene by competing on price (Remember Jio shaking up the telecom world with it’s low-cost offering?)
(IV) High Switching Costs: When the cost to switch between companies is really high, the customers do not do so unless the offering by the competitors is THAT lucrative (Eg: higher interest rates on Fixed Deposits in another bank). In such cases, the risk of losing customers is minimised.
How do we evaluate an Economic Moat?
- Evaluate a company’s historical performance: Analyse the consistency of it’s profitability, earnings growth and other KPIs over time.
- Along with solid historical performance, evaluate the source of it’s profitability: Is it imitable? Is it proprietary?
- How long can the company maintain it’s market dominance and competitive advantage?
- How does the industry’s playground look like? Are there too many players on the field or is there a business equivalent of Ronaldo dominating the ground?
In a future article, I would be taking on case studies to delve deeper into this exciting concept of an “Economic Moat”. And that’s a wrap for this week! Stay tuned for new articles every week, simplifying Finance for Gen A to Z.
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