Thursday, 6 March 2014

Economic Moats: A Successful Company's Best Defense

Cash flow generation, debt-free balance sheets and a significant and sustainable competitive advantage in the marketplace are some of the reasons great companies stand out from the pack.

What is it that separates companies that thrive for decades from the ones that flounder for years?

The answer may lie in what is referred to as a company's economic moat, a phrase popularized by investing legend Warren Buffett. In this article, we'll introduce you to the concept and explain why it is so important to consider as a long-term investor.

What is an Economic Moat?
Economic moat refers to the character and longevity of a corporation's competitive advantage over similar companies competing in the same industry. If Company A is producing excess profits, competitors B, C and D will soon take note and attempt to enter the industry and do the same. As capital flows into the industry, the new competition will erode their profits, unless Company A has an advantage over its competitors.

An economic moat is a barrier that protects a firm and its profits from competing firms. Just like a medieval castle, the moat serves to protect those inside the fortress and their riches from outsiders. Without a wide economic moat, there is little to prevent competitors from stealing market share and thus profits.

Not All Moats are Created Equally
However, not all competitive advantages are created equal. Some companies' economic moats are sustained for decades while others disappear quickly. The trick is determining the difference. In addition, it is important to know when a company actually has an economic moat and when it does not. For example, some investors mistake a technological advancement with an economic moat.

Take, for example, Palm Inc.'s (Nasdaq:PALM) Palm Pilot product line. For a while, PALM enjoyed a considerable advantage, until competitors realized how lucrative this type of product was and entered with a vengeance. Once names like Sony (NYSE:SNE), Hewlett Packard (NYSE:HPQ), Research in Motion (Nasdaq:RIMM), Nokia (NYSE:NOK), and even Microsoft (Nasdaq:MSFT) stepped in, PALM's success was all but over and its share price dropped sharply.

This is an example of a company without an economic moat. If competitors are easily able to compete with little or no barriers to entry, a moat does not exist.

In contrast, other companies enjoy wide economic moats for long periods of time, reaping huge profits for many years. An example of a sustainable competitive advantage is Wal-Mart (NYSE:WMT). Wal-Mart's rise to massive market capitalization from its modest beginnings was largely a result of its aggressive cost controls and subsequent low price advantage over competing retail outlets.

Once Wal-Mart grew to a mega cap company, it enjoyed further cost advantages afforded by its size, buying power and enviable distribution network. Retailers that have attempted to go head to head with Wal-Mart on a price basis have not fared well. Wal-Mart's buying power and infrastructure have created a wide and sustainable economic moat. Competition cannot easily recreate the brand recognition, economies of scale and technical marvel that is Wal-Mart's distribution network.

A company's economic moat represents a qualitative measurement of its ability to keep competitors at bay for an extended period of time. This translates into prolonged profits in the future. Economic moats are difficult to express quantitatively because they have no obvious dollar value, but are a vital qualitative factor in a company's long-term success or failure and a vital factor in the selection of stocks.

How Moats Are Created
There are several ways in which a company creates an economic moat that allows it to have a significant advantage over its competitors. Below we will explore some different ways in which moats are created.

Cost Advantage
As exemplified by Wal-Mart's prolonged success, a cost advantage, which competitors cannot replicate, can be a very effective economic moat. Companies with significant cost advantages can undercut the prices of any competitors that attempts to move into their industry, either forcing the competitor to leave the industry or at least slowing or stopping its growth. Companies with sustainable cost advantages can maintain a very large market share of their industry by squeezing out any new competitors who try to move in.

Size Advantage
Being big can sometimes, in itself, create an economic moat for a company. At a certain size, a firm achieves economies of scale. This is when more units of a good or service can be produced on a larger scale with lower input costs. This reduces overhead costs in areas such as financing, advertising, production, etc. (To learn more, read What Are Economies Of Scale?)

Large companies that compete in a given industry tend to dominate the core market share of that industry, while smaller players are forced to either leave the industry or occupy smaller "niche" roles. Two examples of industry giants are Microsoftand Wal-Mart.

High Switching Costs
Being the big fish in the pond has its advantages. When a company is able to establish itself in an industry, suppliers and customers can be subject to high switching costs should they choose to do business with a new competitor. Competitors have a very difficult time taking market share away from the industry leader because of these cumbersome switching costs.

An example of a switching cost would be changing your cable or satellite provider. Whether its Comcast (Nasdaq:CMSCA), DirecTV (Nasdaq:DTV) or EchoStar Communications (Nasdaq:DISH) providing your service, once you have that company's system in place, the switching costs can be a big deterrent to changing providers.

Another type of economic moat can be created through a firm's intangible assets, which includes items such as patents, brand recognition, government licenses and others. Strong brand name recognition, enjoyed by companies like Coca-Cola (NYSE:KO), McDonald's(NYSE:MCD) and Nike (NYSE:NKE), allows these types of companies to charge a premium for their products over other competitor's goods, which boosts their profits. (For more on this, see Advertising, Crocodiles And Moats and The Hidden Value Of Intangibles.)

For another example, consider drug companies like Pfizer (NYSE:PFE), Merck (NYSE:MRK), GlaxoSmithKline(NYSE:GSK) or Novartis (NYSE:NVS) and the intellectual patents on specific drugs they hold. Their rights to specific pharmaceutical products can effectively bar all competition from successful drugs for the duration of the patent, giving the company guaranteed long-term profits and market share. Once the patents run out, they are susceptible to competition from generic drug manufacturers.

Soft Moats
Some of the reasons a company might have an economic moat are more difficult to identify. For example, soft moats may be created by exceptional management or a unique corporate culture. In contrast to a wide moat, the strength and impact of the competitive advantage aren't as considerable and are more susceptible to competitive pressures.

While difficult to describe, a unique leadership and corporate environment may partially contribute to a corporation's prolonged economic success, even while operating in a less than robust industry. (For more insight, read Governance Pays.)

An example of unique corporate culture transferring to the bottom line might be the story of Google (Nasdaq:GOOG); many people attribute the company's unconventionally open and innovative corporate culture as a contributor to its success.

Difficult to Define But Vital
Economic moats are generally difficult to pinpoint at the time they are being created. Their effects are much more easily observed in hindsight, once a company has risen to great heights. Indeed, many of the retail outlets that were decimated by Wal-Mart's historic growth in size did not see the threat coming until it was much too late.

From an investor's view, it is ideal to invest in growing companies just as they begin to reap the benefits of a wide and sustainable economic moat. In this case, the most important factor is the longevity of the moat. The longer a company can harvest profits, the greater the benefits for itself and its shareholders!

By Chris Gallant on October 04, 2009

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