The word Moat was introduced to the investing world by Warren Buffett. Moat refers to the competitive advantage which one company enjoys over other companies in the same industry. The wider the moat, greater and more sustainable is a competitive advantage.
There are basically four things that create economic moat for any business
1. Economies of Scale
Economies of scale in simple words means that as the output goes up, the capacity utilization goes up, the cost of operation goes down. Let’s understand this with an example lets say you have a 4 seater car whose mileage is 20 km/liter of diesel fuel. The cost of diesel is 60 Rs per liter. If you utilize only 25% capacity of your car that is you travel alone. Your cost of travel will be 3 Rs per Kilometer. While if you utilize the 100% capacity of your car and travels with three more people then the cost will go down to 0.75 Rs per kilometer.
Like your car has fixed a cost of operation which remains the same whether you travel alone or with 3 more passengers, companies business have fixed cost which remains the same. When the capacity is utilized to maximum level the overall cost of operation goes down and this results in an increase in profitability. This is called as economies of scale.
There are two types of economies of scale
- Supply-side Economies of scale
- Demand-side Economies of Scale (Network Effects)
i. Supply-side economies of scale
Supply side economies of scale occur when the companies average cost per unit falls as the scale of output or the number of units is increased. The classic example of supply side economies of scale is Maruti. The development of the car is a costly thing. When many cars are produced the development costs get divided to many units and this results in an average cost per unit going down. Because of these economies of scale Maruti gets bargaining power over suppliers. They get lower prices from their suppliers because they buy in bulk quantity.
The same economies of scale can be with IT companies. The production cost of software is very close to zero. Software applications do not require physical components, so producing more copies of an existing software costs next to nothing. The more software the company sells better will be the margins and profits. This is the thing that makes Microsoft the king.
ii. Demand Side Economies of scale The network effect
The network effect or the demand side economies of scale happens when the value of the product or service increases as the number of users increases. Companies like Facebook, Apple, Microsoft, Page industries etc are the examples of this network effect. Though there are many other social networking websites but a new user will most likely open his account with facebook because it is popular, his friends are already there .
Brand is an another moat creating thing. Companies with strong brand power do well in long term. They can charge high price which their competitors can’t. But be cautious not every brand has moat. A brand creates an economic moat ONLY if it increases the consumer’s willingness to pay Brand which doesn’t have pricing power or repeat business capacity is a brand without moat. A company with brand moat can increase its price continuously without losing any customer.
3. Regulations and Patents
There are many businesses where government or other regulations are so high that other companies can’t enter that business. The existing companies can continue to make good profit because they don’t have to face much competition.
Similarly, Patents creates moats Companies which have been granted a patent or other type of intellectual property right by a government gets a legal monopoly.
4. Low cost of operation
Some companies can be a low-cost producer than others because they can procure raw material at a lower price which others can’t. Cement companies having own lime stone mines can produce cement at low cost compared to those who buy lime stone from others. Thermal Power companies having own coal mines near to their plants will have this kind of moat. They get coal at a low price they don’t have to spend much on transportation as their plant is near. Their cost per unit can be much lower than their competitors. They can earn more even by selling at the same price as their competitors.
Why invest in moat rich companies?
- Understanding moats will help you separate the here today and gone tomorrow business.
2. If you are right about the moat, your odds of permanent capital loss will decline to zero.
3. Companies with moats also have greater resilience, because firms that can fall back on structural competitive advantage are more likely to recover from temporary troubles
Moat may not be sustainable forever. Colgate had a strong moat because of its brand power and it has 70% market share in toothpaste market. But because of Patanjali Dant kranti its moat is destroying. Moat can destroy when the patent expires and the company does not have other patented product to replace the existing one. Therefore, investors should keep a watch on the sustainability of moat. To know more about moats you can read the book.
Abhishek is an Engineer MBA in Finance and Certified Research Analyst. He is an active trader and investor in the stock market since 2010. Follower of the philosophies of Warren Buffet and Peter Lynch in investing and trend following in trading.