You may have heard legends of castles surrounded by huge moats from the Middle Ages. The purpose of these moats was to keep invaders out. The castle would be more defended if the moat was larger and deeper.
The higher the Moat's strength, the better. Companies, too, have moats. They aren't literal moats, of course. They're all metaphors. As an investor, understanding these moats may be beneficial.
The term "MOAT" is commonly used in the investment world to describe a competitive advantage. A company's "Broad moat" refers to its competitive advantage over other firms in its industry.
In a broader sense, it may refer to anything in a company's operations that can safeguard it in the long run. You may use these moats to determine if a firm can endure adversity.
Warren Buffett coined the phrase "Economic Moat," which refers to a company's capacity to retain a competitive edge over its competitors in order to safeguard long-term earnings and market share from competitors.
The moat, like the moat of a medieval castle, protects residents inside the stronghold and their wealth from intruders.
Buying a firm, according to investors like Warren Buffet, is similar to purchasing a castle.
Warren Buffet (source)
Buffett highlights the value of purchasing firms with deep moats, which are insulated from competition and so can retain high profitability.
It is frequently a competitive advantage that is difficult to imitate or reproduce (e.g., brand identification, patents) and so serves as an effective barrier to entry for other businesses.
In order to evaluate that advantage, you must first determine what type of defense or competitive barrier the firm has been able to construct in its industry.
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Understanding an Economic Moat
Moats are significant from an investing standpoint because when a business creates a valuable product or service, it doesn't take long for other companies to try to cash in on the opportunity by creating a similar—if not better—product.
In a fully competitive market, rivals would eventually gobble up any extra profits produced by a successful firm, according to basic economic theory.
In other words, competition makes it difficult for most businesses to sustain long-term development and profitability since any advantage is always vulnerable to imitation.
Watch this video from MorningStar Europe on “What is an Economic Moat”:
Remember that competitive advantage is simply any aspect that allows a business to deliver a product or service that is identical to that of its competitors while outperforming those competitors in terms of profitability.
A low-cost advantage, such as cheap access to raw resources, is an example of competitive advantage. Buffett and other great investors have a knack for spotting businesses with strong economic moats but low stock prices.
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Why is an Economic Moat necessary?
Any product or service will ultimately be replicated in a free market. All businesses run their operations with this reality in mind. As a result, as vital as it is to develop and provide products and services, establishing a commercial moat is also critical.
If a firm does not have a moat, it will not be able to compete, regardless of how large or profitable it is. Rivals will eventually create comparable or identical items, and earnings will begin to flow in their direction.
No firm can guarantee that its products and services will never be duplicated. Even global corporate behemoths such as Coca-Cola, PepsiCo, Apple, Microsoft, and Nestle can't ignore the threat of rival replication.
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Temporary protection can be provided through patents, copyrights, and trademarks. However, a long-term competitive advantage (economic moat) must be established (gradually, over time).
Companies with a narrow moat outperform those without one (no competitive advantage). However, in order for a firm to be successful over time, it must create a broad moat.
These businesses continue to be investors' favorites because they may generate significant returns over time.
How is an Economic Moat created?
Some businesses, such as Walmart, P&G, Asian Paints, and Dabur, may take years to attain a particular level of success.
New-age technology or digital firms, on the other hand, may attain inconceivable heft, size, and values in a few years — Apple, Amazon, Infosys, and TCS, to mention a few.
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They were able to build a persistent edge over peers by combining the techniques listed below, no matter how long it took.
Different Methods of making an Economic Moat
There are numerous methods for a firm to build an economic moat that gives it a considerable competitive edge over its competitors. We'll look at a few different techniques to make a moat in the sections below.
A cost advantage that competitors are unable to match might be a powerful economic moat. Companies with considerable cost advantages can undercut any rival attempting to enter their sector, pushing the competition to quit or at the very least limiting their growth.
Companies with long-term cost advantages can keep a substantial part of their industry's market by pushing out any new competitors who try to enter. A smart business maintains a balance between price and quality.
If a consumer perceives a product's price to be too high, they may reject it even if it is of the highest quality. Cost is an important component in value generation. It's one of the reasons why a low-cost manufacturer outperforms the competition.
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Being large can occasionally provide a firm with an economic moat. A company gets economies of scale when it reaches a particular size. This occurs when a higher number of units of a commodity or service can be produced with lower input costs.
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This lowers overhead expenses in areas like finance, advertising, and production, among others. Large firms that compete in a particular sector tend to dominate the industry's main market share, forcing smaller competitors to either quit the field or take on smaller "niche" responsibilities.
Watch this video on how to make a strong Moat -
High Switching Costs
There are additional benefits to being the big fish in the pond. Suppliers and consumers may face significant switching costs if they choose to do business with a new rival once a company has established itself in the industry.
Because of the high switching costs, competitors have a tough time stealing market share from the industry leader.
It makes customers feel good about owning its items. Certain brands' products are seen to be more trustworthy than others. For some people, some brands become status symbols.
Building a brand name takes time and work, but it is worthwhile. It may provide the firm a significant competitive edge by ensuring value for all stakeholders.
After Sales Services
It has acquired increasing traction in value generation for current clients during the previous few decades. There will always be those consumers who have issues with the company's products or services.
It is critical how a firm treats such consumers. It's fantastic to make a disgruntled client happy. Customers like this promote goodwill through word of mouth. As a result, new consumers may be attracted to the firm.
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Some of the factors that contribute to a company's economic moat are more difficult to pinpoint. Soft moats, for example, can be built through excellent management or distinct business culture.
A distinctive leadership and corporate climate, albeit difficult to explain, may play a factor in a company's long-term economic success.
Process of creating an Economic Moat
How Economic Moats Convert into Profits?
Companies have pricing power because of the economic moat. What does it mean to have pricing power? There will be no drop in demand if the firm raises the price of its goods or services.
BMW, Bose, Rolex, Gucci, Harley Davidson, and other luxury brands are examples. The moats around these few firms (brands) are the widest.
They've developed a cult following among their clients. People will purchase them regardless of the circumstances. Customers who own such brands' items have a feeling of pricing.
People often extend their budgets to acquire these businesses' items because their desire for them is so strong. As a result, the firm gains pricing power, which leads to increased profits (growing EBIT, PAT, and EPS).
How to Identify Moat Companies?
This is a separate topic. The people who undertake this study spend months looking for firms like this. However, we do not need to dive too far into it. The company's long-term profitability and scale will be our screening criteria.
Follow these four steps to assess whether a firm has an economic moat:
- Assess the company's profitability in the past. Is the company generating a good return on its assets and shareholder equity? This is the most crucial factor in determining whether or not a firm has a moat. While much of judging a moat is qualitative, reliable financial measures remain the backbone of firm analysis
- Assuming the company has a good return on capital and is regularly successful, attempt to figure out where the profits are coming from. Is the source a competitive edge that only this business possesses, or one that other firms can readily copy? The more difficult it is for a competitor to copy an advantage, the more probable the business has an industry barrier and a source of economic benefit.
- Determine how long the firm will be able to fend off competition. This phase is known as the company's competitive advantage period, and it can last anything from a few months to many decades. The larger the economic moat, the longer the competitive advantage period.
- Consider the competitive structure of the industry. Is it lucrative, or is it hypercompetitive, with only a few enterprises fighting for every last dollar? Over time, highly competitive industries are likely to deliver less appealing profit growth.
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From the perspective of an investor, it is ideal to invest in expanding businesses just when they are beginning to reap the benefits of a broad and long-term economic moat. The duration of the moat is the most crucial element in this situation.
The higher the benefits for a firm and its stockholders, the longer it may reap profits. A firm with a large moat is likely to be worthwhile to invest in.
It may be lucrative in both good and poor times, and it can recover quickly following negative news. It's also perhaps the best in its industry.