Persistence is key for a company to give investors excellent returns for many years.
A company needs to do something very well over an extended period to become a great investment.
So, how can you know a company still be profitable in 20 years or more?
How can you identify a bad company from a good one?
Or a good company from a great one?
Here comes a topic of Economic moat!
What is an Economic moat?
An economic moat is a competitive advantage.
A moat keeps competitors out from reaping firms’ profits.
Different types of economic moats offer different advantages.
For example, The man opened a restaurant near the college.
Where most students come to eat.
They will prefer a restaurant near the college relative to a restaurant 2 km away from their college.
The restaurant has a location advantage over its competitors.
For a restaurant, the location is their Economic moat.
Moats allow a company to retain above-average levels of profitability for many years.
A prolonged period of excellent profitability, the greater the stock performance.
Great investor Warren Buffet popularizes the economic moat term.
This is one of the key parameters Warren Buffet looks at while analyzing a business.
What is a wide and narrow economic moat?
There are two types of the economic moat:
1. Narrow economic moat: There’s depth. How much money the company can make.
It is usually short-lived.
Narrow economic moats are incredibly profitable over a short time.
2. Wide economic moat: There’s width.
How long the company can retain its profits.
Although it is tough to identify narrow and wide economic moat.
Just try to separate companies while analyzing which one is wide and which one has a narrow moat.
And make a decision based on how long you wanted to invest.
If you want to invest for a short-term time then a narrow moat is best for you.
Conversely, for a longer period, a wide economic moat is best for you.
Why is it essential to find an Economic moat in a business?
A genuinely great business must have an enduring economic moat that protects excellent returns on invested capital.
The bigger the company’s profit, the higher the chance it will attract competitors.
Despite developing a better product or service there are always competitors who are making even products than that.
Eventually, competitors can eat up companies’ profits by creating products better than theirs.
Competition makes it difficult for a business to generate profits over the long run.
whereby it will affect your investment in a company.
You must look at wide economic moats to check companies’ sustainability and profitability over the long run.
Give enough time to find an economic moat in a business.
It will maximize your return on investments.
Let us now look at 6 types of economic moats you can find in a business.
6 Types of economic moat
There are numerous moats you can find in a business but here are some:
1. Product differentiation
It is a most obvious type of economic moat.
However, product differentiation is not a sustainable strategy because there are always competitors trying to make a better smartphone.
While making a product differentiation company can increase the price for a better product than others in the market.
Many customers prefer a slightly low-quality product at a significantly lower price.
Therefore it is usually a short-lived strategy.
Product differentiation comes under a narrow economic moat.
Although the business-like Coca-Cola is still famous for its taste.
Yes, Coca-Cola has a product differentiation moat.
2. A reputable and strong brand
The company creates a brand when it consistently makes a better product and offers better services.
A strong brand creates a very wide economic moat.
A Colgate company has a brand.
In India, people are most likely to say “do you have Colgate (Colgate hai kya)” in a store than ask for toothpaste.
Apple has a strong and reputable brand.
Costumers are willing to pay more for a product in one company than another.
While brands make the company more money, you must look at how much profits it is generating from its brand.
You do not have to just look at the existence of brands but how the brand is used to make excess profits.
3. Network effect
The more company’s products or services people use, the more the value of the product increases for customers.
It’s hard to beat an Instagram now.
Instagram has a network effect moat.
Everybody uses Instagram. And so, you also wanted to use it.
Instagram and WhatsApp have already lots of users whereby existing customers don’t use different apps.
Coming with social media platforms now, it’s like they are creating Facebook today.
Examples of network economic moat are:
It is very hard for competitors to break their network moat.
4. Price advantage
Similar product offerings at lower prices other than the market can be an incredibly powerful competitive advantage.
In general, the company can create a price advantage by two strategies:
- Inventing a better process and
- Going larger scale (like D-mart)
In commodity, industry products are hard to product differentiate.
Low-cost strategies especially work best in this type of market.
A low-cost strategy works best as well as the price advantage is sustainable and not temporary.
Until the company is selling its product or services cheaper than everybody else, it has a moat.
5. High cost to switch
Creating high switching costs is a wide economic moat for a company.
Also, it is the subtlest type of competitive advantage.
The switching cost does not have to be monetary.
Most of the time customers don’t go for the other product just because of time.
If you’re using Ms-excel for a long time, you know how to use it.
But if you switch to the other product, you need to learn how to use it.
Therefore, people tend to stick with the same product.
Bank has a high switching cost moat.
All banks have the same product.
The survey found by the Bankrate, people tend to stay at their banks for an average of 17 years.
6. Biggest in size
The biggest is also an advantage.
It keeps competitors out.
Competitors are unlikely to compete with you if you’re the biggest in a niche market.
When companies are the biggest, they buy their Inventory in a bunch.
Whereby they reduce the price of their product.
Think of if you’re opening a company as opposed to TATA.
Put some time to find a moat in a company.
The moats are not easy to identify all the time.
Therefore, you should look at the clear sign of economic moat in a business.
Look at the financial statement to get clear evidence of moat.
The higher the gross margin than the competitors, the better.