The concept of economic moats is the cornerstone of value investing. Successful investing is not limited to finding undervalued stocks, with high growth and strong financial history. The most important aspect of value investing is evaluating whether the business will stand the test of time. It is the ability of the business to adapt to rapid changes that determines how strong and wide the economic moat of the business is.
What is Economic Moat?
To define, An economic moat is a long term durable advantage of a business that allows the company to earn better profits, improve capital efficiency, and most importantly, keep competitors away from taking their market share.
For example, companies like Coca Cola have strong economic moat as they have a patented product which cannot be produced by any other company in the world. Secondly, Coca Cola has created a strong brand image, helping them in gaining loyal customer base.
Companies with wide moat will create lot of value for themselves in the form of high profits, healthy margins, customer loyalty and brand name as well as for their shareholders in the form of consistent return on capital, and healthy dividends.
But how can a company create an economic moat? Well, different companies use different strategies, we will discuss 5 ways that a company can use and create a wide economic moat around their business.
How Can A Company Create Economic Moat?
Well, different companies use different strategies, we will discuss 5 ways that a company can use and create a wide economic moat around their business.
Branding
This is the most powerful economic moat that a company can create. Brand is all about trust. When people trust a brand they become loyal customers, helping companies generate repeat sales, without much effort. Companies that do not have strong brands lack this loyal customer base and have to spend lot of time and energy to make each sale.
Secondly, when people trust a brand, they happily pay a premium price for the product or service of the company. For Example, Cosmetic products by Lakme are usually more expensive than local, or less known cosmetic brands. Customers who are loyal to Lakme brand are aware of the quality of their products and are willing to pay higher price for the same. This does not necessarily mean that the products of non branded companies are inferior in quality, but since people trust Lakme for its quality, they do not mind shelling out few hundred extra for it.
Patents
Many companies can use patents as a means to create economic moat. This is especially true in case of pharma and consumer companies. One of the best examples of patents is Coca Cola. The Coca Cola Company has a secret formula for their beverage, which is known to two people in the world. Since Coca Cola owns the patent to this formula, no other company can copy its taste, allowing Coca Cola to enjoy monopoly over the entire market. This provides strong pricing power to Coca Cola on its product and people who love them will be happy to shell out more for their product. Coca Cola thus commands high profit margins, which cannot be taken away from them ever. The result is, Coca Cola serves 8 billion servings of its beverages everyday across the world. No wonder why it’s one of the favourite companies of Warren Buffett.
High Barrier to Entry
Many businesses are very difficult to understand and setup as it requires lot of knowledge or capital to begin. Because of this difficulty, very few player can actually enter such business. One of the best examples of high entry barrier is the Airline business. Airlines being a highly capital intensive business to set up and operate cannot be started by anyone. This allows fewer players to enter and creates a strong economic moat for the companies (though ost airline companies are struggling to make profits due to high fixed costs).
Innovation
Innovations is doing things differently. When companies create a completely new product or a business model that is hard to copy easily, it provides a strong economic moat. One of the best examples of business model innovation is Amazon. Starting as a bookseller Amazon now sells almost anything in the world. Being able to shop anything from any corner of the world was the greatest innovation in the recent times. No wonder Amazon is now the largest online retailer in the worlds with almost a monopoly in the market. Other players like Flipkart are simply replicating the business model setup by the Amazon.
Switching cost
A high switching cost can also act as a strong economic moat. Switching cost is the cost a consumer has to pay to switch over from one company’s product or service to the other one. When switching cost to a customer is high, customer hesitate to change the product or service provider. One of the examples of switching cost is Online streaming service provider Netflix.
Netflix creates original and exclusive content for its online platform.
If a customer wants to switch from Netflix to other online streaming platform, he will not be able to access the unique content presented by the Netflix. This provides Netflix a strong economic moat where users have to pay what Netflix asks in order to gain access to the exclusive content.
Also Read: 5 Things Warren Buffett Looks for Before Investing
Conclusion:
Economic moats are the most important aspect for the longevity of a business. Companies that successfully create economic moat not only manage to survive for a longer period of time, but also keep their competitors at bay.
Form an investor’s point of view, companies with strong economic moat provides pricing power to the business, enabling them to charge a premium for the product or service. This not only helps companies maintain strong profit margins,in the long run businesses like these also perform consistently, creating wealth for shareholders.