When we are doing fundamental analysis on a stock, we will look at both the quantitative analysis and qualitative analysis. One of the key factors to look at in qualitative analysis is Economic Moat. Economic Moats are competitive advantages that a Corporation has which competitors within the same industry do not have. World renowned investor Warren Buffet coined the term Economic Moat in his search for businesses which could withstand the test of time. The broader the Moat, the more difficult it is for its rivals to get ahead of them and the more sustainable the advantage. The Economic Moat surrounds the Castle which is the Company, a medieval metaphor for a huge barrier. We will discuss 8 types of Economic Moats in this article
1. Economies of Scale, Low Cost Advantage
Economies of Scale usually apply to very large companies which can provide comparable products or services at a relatively lower cost. Due to the low cost advantage, they can offer more competitive pricing, thereby undercutting their competitors. A good example is Dell, a low-cost producer of personal computers. Dell’s huge size allows it to negotiate favourable costs, and its direct-sales distribution structure allows it to sell computers more efficiently than competitors who go through resellers. Economies of scale also serve as a barrier to entry for new entrants as the firms have to reach critical mass before they can be profitable. A good example is Wal-Mart, which has a low cost advantage as they source their products directly from China and have massive bargaining power due to their large consumption.
2. Strong Brand Name
Coca Cola, McDonalds and Johnson & Johnson have a huge Economic Moat in their Brands. These brands are so resilient and long-standing that their Brand equity itself is worth billions of dollars. Their brand names are synonymous with the product itself, when one thinks of Cola, the first word that comes to their mind is Coke; when one thinks of fast food, and the brand that comes to their mind is McDonalds. Furthermore, these Companies also spend a huge amount on branding to make sure their brand continues to be the top. There is no way a new Company can replace these revered brands within their industry in a short time span.
3. High Capital Requirements
High Capital Requirements in Capital Intensive Industries such as Utilities, Infrastructure and Telecommunications also serve as an Economic Moat. It can cost hundreds of millions of dollars to set up the network, power plants and the infrastructure. Due to the huge capital investments required, the Companies may require a very long time to breakeven on their investment. As such, they are also often legalized monopolies or oligopolies. Telco Companies such as Detroit Edison Energy and AT&T are good examples which have few competitors able to compete directly with them.
4. Regulated Monopolies and Oligopolies
Due to huge capital requirements and high breakeven levels, industries such as Transport and Infrastructure are designed to be Monopolies or Oligopolies. It doesn’t make sense to allow hundreds of Power operators or Railway operators, then all of them would be inefficient and loss making due to diffusion of customers. Therefore the Government restricts the sector to only a few selected operators. These Companies also usually receive government funding or grants for large scale projects, so it is very difficult for new Companies to enter these sectors.
5. Economic Moat - Intellectual Property
Intellectual properties include Patents on technologies, medicine; Copyrights to protect books, music labels, movies and more. Pharmaceutical companies such as Pfizer have Patents such as Viagra and other important drugs which guarantee revenue for a specific time period for them to claim back their research and development costs and make good profits as well. However, there is usually an expiry for drugs since generic drugs could be produced at a much cheaper cost and sent to poorer places which need the medicine. Universal Music also owns the Copyrights to timeless songs such as those sung by Beatles and will continue making money from despite the band having disbanded a long time ago.
6. Natural Resource
Political connections are often required to even have the rights to mine Natural Resources such as oil and gold. Beside connections, the Company will also need to have large amounts of Capital and the technology to run mining operations. Such natural resource Companies usually are Government affiliated since these deposits are prized assets of the country. Shell, British Petroleum and Petronas are good examples of Companies which have access to Natural Resources which give them a huge advantage.
7.The Network Effect
Facebook have billions of users around the world which makes it service very valuable for people to build their network on. In fact, the more people that join the network, the more potential it has. The network effect occurs when the value of a particular good or service rises for both new and existing users as more and more people use that good or service. It is almost impossible for any other competitor to provide the same value that Facebook does, for they would need a lot of subscribers before they can hit the critical mass required for the network effect. Network Effect can also happen when other firms design products that compliment an existing product, thereby enhancing that product's value. We can see this in the Apple IPhone, with millions of third party applications produced for the IPhone, Apple has virtually overtaken every single cell phone company. The reason many people choose IPhone as opposed to other smart phones is the vast number of applications available through the Network Effect.
8. High Switching Costs
Switching costs are the one-time inconvenience or expenditure a customer has to incur to switch from one product or service to another. When switching costs are high, a customer is more likely to stay with a particular Company to save costs and time, such as the cancellation charges imposed by mobile phone providers and the hassle required to change numbers. Customers would therefore require a large enough improvement in either pricing or performance to make the switch to another product worthwhile. Examples of this are cell phone service providers which often charge huge switching costs therefore encouraging a customer to stay with their service. Switching costs may also come as a result of having to retrain the employees to use different tools or software. For example, once an engineer has learnt to use AutoCad to design the product models, the Company would have to incur huge retraining costs if they switch the software since they can be very different.
These 8 Economic Moats are very important in picking quality stocks for your portfolio. The wider the moat, the more defensive the Company is and the more sustainable the advantage is.