Investopedia defines an economic moat as:
“The competitive advantage that one company has over other companies in the same industry.”
Warren Buffett is renowned for using this principle as a central part of his investment philosophy. It is important to distinguish however, the difference between a competitive advantage and an economic moat. A competitive advantage is any advantage that currently allows a company to earn premium margins over its competitors. An economic moat is a sustainable competitive advantage.
In theory, it seems comprehensible, rational and logical. However, most investors lack the proficiency and awareness to identify superior companies that are surrounded by an economic moat.
Castles, Capitalism and Competition
Warren Buffett famously describes the ownership of an exceptional business with the idea of owning an economic castle. Buffett explains however, due to the nature of capitalism, other people will always want to take your economic castle.
“Capitalism is all about somebody coming in trying to take the castle”
What does he mean by this? A company with a great product or service is likely to earn abnormal returns. Consequently, others will see this as an opportunity to enter the market primarily to steal your abnormal returns, with the end goal of conquering your economic castle.
“What you need is a castle with some form of durable competitive advantage, thus an economic castle with an economic moat around it to protect the corporate profits from its fierce competitors.”
An individual with a long-term investment horizon will want to purchase an economic castle with a wide economic moat around it. It is imperative for an investor’s confidence and psychological stability to invest in businesses they can foresee generating returns well-in to the future.
Identifying Economic Castles with Economic Moats
A qualitative and quantitative approach can be used to assess whether a company has an economic moat.
Barriers to Entry
Competitors who are able to compete with little or no barriers to entry signifies a castle with no economic moat.
Companies that hold a significant cost advantage can undercut the prices of any competitors that attempt to move into their industry, thus giving the company a competitive advantage. It is worth considering however, whether the cost advantage a company possesses is sustainable in order to maximise future economic returns.
Consumers tend to purchase products/services from companies who hold a strong brand. Brand recognition is a fundamental characteristic of a company that can fend off competitors for long periods of time, consequently widening an economic castles moat. However, it is important to be due-diligent. Brands can diminish rapidly if the owners lack integrity, as we have seen with Volkswagen. Volkswagen is an internationally recognised brand with strong appreciation across the globe, however a lack of managements integrity led to the share price plummeting nearly 20%, the biggest one-day fall in its public history. That being said, an initial reaction was inevitable, but the collateral damage is yet to be realised.
Patents can provide monopoly conditions, creating the perfect economic environment for a company to endure a sustainable competitive advantage. A great example is General Electric Co (GE), who hold $14.2bn in intangibles relating to patents, copyrights and secret processes.
Switching costs are the negative costs that a consumer incurs as a result of changing suppliers, brands or products. Broadband, cable and satellite providers are experts at this, ensuring that switching costs are high in order to retain consumers, preserving market share and consequently safeguarding present and future earnings.
In most cases, switching costs can be expressed in monetary terms, although there are also psychological and effort/time-based costs for the consumer.
A large company can exploit economies of scale which can be enough to create an economic moat. This is where more units of a good or service can be produced with lower input costs. The exploitation of economies of scale can push down overhead costs, subsequently allowing the company to sell its goods at lower prices and hence maintain the size of its economic moat.
Free Cash Flow
The most obvious sign of an economic moat is the company’s ability to generate a higher rate of free cash flow. Free cash flow is the cash generated by a business after capital expenditure has been paid off.
It is important to compare companies within the same industry, as some industries are more capital intensive than others and therefore impacting the level of free cash flow. The Chief Executive of Amazon.com Inc., Jeff Bezos was quoted saying:
“It’s the absolute dollar free cash flow per share that you want to maximize. If you can do that by lowering margins, we would do that. Free cash flow, that’s something investors can spend.”
Free cash flow can either be reinvested or paid out as dividends, making it an important consideration within an investor’s strategy when identifying exceptional companies.
Return on Capital & Equity
If a company can consistently generate high returns on capital and equity, it is likely to have some form of competitive advantage, such as pricing power or a cost advantage.
Beware of False Moats
As with all investment philosophies, it is important to be prudent. Assessing whether the company’s competitive advantage is sustainable is essential for any long-term investor. Despite the extensive research an investor may have to endure, shareholders of such unique companies will be rewarded tremendously.
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