It is the nature of capitalism that avenues of high returns on capital get competed away over time. If Restaurant A is making 20% on capital running a new restaurant in a certain neighbourhood, in the next few years, competitors will enter, offer cheaper prices and eventually wither away these returns. Charlie Munger once said:
Therefore, to make a successful investment, a business must be able to maintain high returns on capital over the very long term. As a result, we need to find businesses that have an intrinsic characteristic that can prevent competitors from entering the market and taking away from the great returns our business is already making. This is where business competitive advantages or moats come in. Warren Buffett described this idea in Berkshire Hathaway’s 1995 shareholder meeting:
Below, we will discuss the type of moats businesses can have, how they develop, and how durable they can be.
A brand moat is an intangible advantage that garners trust from consumers and often demands a premium in the price of the product.
The idea of a brand is to have consumers believe in a promise the business is developing. Brands such as Coca-Cola, Nike and Lindt & Sprüngli developed their brands by offering unique products and decades of intelligent advertising.
The good thing about a brand is once it is established and dominant in a market, it is very difficult for it to be displaced. Would you buy Snowball Investing Cola for 10% less than Coke? Or Snowball Investing chocolate for 20% less than Lindt & Sprüngli? Probably not! You wouldn’t trust the quality or the taste, and you wouldn’t get the feeling of happiness or luxury that other brands garner when you use them. It does often take decades to develop that position in consumers’ minds that a brand is the one to trust, and that its quality and service is worth paying the premium for. Also, strong brands often employ a tactic of having their branding available and constantly seen by consumers, making them even harder to displace. This makes it difficult for new brands to develop and take over the older, more established players.
However, just being well known is not the definition of a brand moat. There are many brands out there that you know of, and that you trust, but that you don’t trust any more or less than its competitors. As a result, the brand name doesn’t garner any premium or market dominance, in which case, it is not an economic moat.
Common features of brand moat businesses
A common feature for businesses with brand moats is a high gross profit margin, indicating high markups on their goods that customers are willing to pay.
|Coca-Cola||Nike||Lindt & Sprüngli|
|Mark-up (1/(1-gross margin))||2.4x||1.8x||2.8x|
Also, most dominant brands required decades of advertising to assert their dominance. As a result, another indicator of a strong branded company is the length of time they have been operating for. This differs between types of brands. If it is a food or drinks business, the brand often needs longer to convince customers to trust them. On the other hand, apparel or equipment brands might not need as long.
|Year brand was founded||Year product was founded|
|Nike||1964||~1880 (branded footwear)|
|Lindt & Sprüngli||1845||~1840s (chocolate bars)|
Brands must also be available when consumers want them. The strongest brands are available for purchase in many locations all over the world. This solidifies their position in consumers’ minds and prevents people from trying alternative products.
A cost edge allows a business to undercut its competition profitably, gaining market dominance and share over time. Sometimes, these cost advantages can lead to scale economies, which we will discuss below.
Some businesses with a cost advantage have a low-cost structure without economies of scale advantages
Some businesses have a model which allows them to profitably price below their competition but do not receive huge incremental gains as they grow. This is quite rare, as the majority of businesses gain huge buying power as they scale, which will be discussed below. Auto-insurance businesses GEICO and Progressive possess this edge. They both use direct methods of selling insurance such as the internet or the phone to avoid paying commissions to agencies in brick-and-mortar locations. As a result, they have both been able to undercut the rest of the American auto insurance market and steadily grow in market share.
Most businesses with a cost advantage possess economies of scale as a result of an innately low cost structure
Economies of scale refers to the ability of a business to leverage its size and buying power to obtain supplies and materials at lower costs than its competitors. This means applying the same mark-up as their competitors would lead to lower prices for consumers, giving them a moat of being the low-cost provider of a certain good or service. As a result, this moat actually gets deeper the larger the business gets. Getting to the size where a business can use its scale as an advantage is not easy. Most of the time, the business must first have an innate feature that gives it a low-cost structure, then over time, they can pair this with the scale they develop to keep competitors at bay. Let’s look at some examples below.
|Xero (accounting software)||Xero and other software companies have high fixed costs in developing the technology and maintaining servers but the incremental cost of selling new software is next to zero. Hence, once they reach a certain scale, they become extremely profitable.|
|Costco||Membership only warehouse operation, reducing costs of maintaining warehouses and storing goods. They also only sell 4,000 unique products in bulk, meaning from their inception, they were able to obtain items cheaply.|
|Walmart||Removing middlemen by having items shipped directly to the stores or warehouses operated by Walmart. Also, choosing cheap buildings that other retailers didn’t want to use. Operating a one-stop shop, fast-tracking their path to scale advantages by offering so many items.|
The cost edge for software companies is less durable since competing software companies can achieve the same result in a short period of time. The best type of cost advantage is where a business can obtain buying power, meaning they can price goods cheaper than the rest!
A competitive advantage from switching costs is where certain products or services would be too difficult and expensive to stop using, giving the provider continuous revenues and the ability to increase prices over time. Developing a switching costs moat does not need as much time as brands or cost advantages. The key to developing this moat is making the switching process not only inconvenient but also very financially costly. Consequently, new competitors will find it near impossible to gain market share since customers just can’t afford to switch.
Businesses such as Microsoft, Apple and Kone benefit from this competitive advantage. The Microsoft suite for example is so entrenched in the corporate world, that if a new spreadsheet provider offered half the price of Microsoft, businesses would still likely reject the offer. Training employees on the new software plus switching off Outlook, PowerPoint, OneDrive, Teams etc just isn’t worth it for most businesses. Kone produces elevators and escalators. Once they install their lifts or escalators in a building, removing them is very difficult. This means every time they need maintenance, Kone will likely be called, meaning again, the customer is essentially locked into doing business with Kone.
Network effects are when a platform becomes more valuable as the number of users increases. If you use a product that is more useful to you the more members there are using it, then that business likely has a network effects moat.
Developing this moat does not take very long, but it can be extremely expensive to do. Profits are usually an afterthought in the early stages of network developments as a shrewd operator knows that if the network gets big enough, they can monetise it quite easily and users will likely be stuck to the product or service.
Some examples of businesses with network effects are Facebook, Mastercard and Uber. All these businesses are valuable to users because the platforms have so many users. Advertisers use Facebook because of the number of members it has. Members use Facebook because all their friends and family are using it. Merchants offer Mastercard as a payment option because they know customers will likely own the cards, and customers use Mastercard because they know merchants will accept it. Finally, using Uber is useful because there is an array of drivers that can pick you up, and drivers get value because there are so many customers that have the app.
The difficulty with a network effect is obtaining it is very difficult. The question is, why would the first user utilise the product? This question is very difficult to answer, making network moats easily identifiable once developed, but nearly impossible to spot during creation. Many of the successful players were early movers in the markets, such as Facebook in social media, Mastercard in payments and Alibaba in Chinese eCommerce.
Some businesses can attain moats by being the only business that can offer a certain product or service, like a toll bridge which takes a fee for letting cars use their bridge. This can be attained either through regulation or in some cases, by the nature of the business.
Examples of regulated businesses with this moat are utility companies. They are essentially legally bound to a certain return on capital. In some areas, only certain utility providers are permitted to sell their products. As a result, they have a regulatory moat keeping competitors away.
Other examples of these that develop without regulation are railroad companies. If you want to transport goods from point A to B and there is a railroad that connects those two towns, the business has a moat around it. This is because competitors won’t get permission to just build a railroad right next to it, meaning the only cheap way to transport goods from point A to B is through the railroad.
Overall, moats are needed to protect a business’s profits from being taken away by competitors. However, this doesn’t mean that there won’t be competitors and business will just be easy. Coca-Cola has Pepsi, Mastercard has Visa and American Express, and GEICO has Progressive and Allstate. Moats just allow a business to operate profitably, employing capital at high rates of return and slowly growing their business either through the market growing or their share of the market increasing.
Also, not all moats are the same size. For example, the trust and premium-pricing brands can demand varies immensely from company to company. In analysing businesses, it is our job to measure how durable and strong a business’ moat really is.