5 Proven Ways to Identify Economic Moats
Value investors are constantly striving to discover the secret behind what makes one company strong and successful over decades, while another may flounder endlessly, or simply collapse altogether.
While regular cash flow, well-managed debt, and a competitive advantage all play a role in enduring business success, the ability to develop a wide economic moat may just be the key to what separates the winners from the losers over the long-term.
What is an Economic Moat?
An economic moat is basically anything that gives a business some form of built-in protection for its ongoing generation of cash flow.
If you picture a typical company as a castle that is constantly under attack by its enemies, or competitors, you’ll have a better understanding of just how important an economic moat is in helping a business to thrive and survive in the marketplace.
An economic moat provides a sustainable and often impenetrable defense against the perpetual assault of price-cutting and product knock-offs.
Without one or more protective moats firmly in place, a formerly profitable business will soon find itself unable to maintain its market share, and its revenues will begin to drop off.
It can be difficult to describe what exactly defines an economic moat, since in many cases it takes the form of some immeasurable, but unique, quality.
Economic moats are not something that can be expressed in dollars and cents, but they are a vital consideration when you sit down to determine the value of a particular stock.
Although factors like an outstanding management team or a unique business philosophy can contribute to the strength of a company’s competitive defenses, those companies that also boast a wide economic moat have either developed the proven ability to command higher prices, or to take advantage of lower costs.
Either way, the end result is greater returns that are both significant and sustainable.
Why a Company’s Economic Moat is Important
As soon as the level of a company’s profits is significant enough to warrant attention, it opens itself up to attack from competitors who are looking to enter the marketplace with the intention of grabbing a share of those profits for themselves.
This is precisely where a wide economic moat offers the protective barrier a business needs to prevent other companies from stealing its earnings.
In reality, an economic moat serves as a competitive advantage over other companies within the same industry, but what sets it apart is the fact that the advantage is sustainable over a very long period of time, if not indefinitely.
While these moats can be created in a number of different ways, and may be either narrow or significantly wide, it only stands to reason that the more of them a business can build, the better off it will be.
In terms of your evaluation of a stock’s potential for continuing to generate positive future cash flows, the presence of an economic moat represents an invaluable consideration.
How can you feel confident about estimating a company’s ability to generate earnings down the road if that ability is not protected in some way?
Sustainability is the key to consistent and ever-growing revenues, and the economic moat is the key to that sustainability.
While the typical competitive advantage may allow a business to temporarily outperform its competitors, the economic moat is a benefit that’s built to last, and it will ultimately determine whether a company is set up for prolonged success, or inevitable failure.
From an investment point of view, the longer a company’s economic moat can hold firm, the longer you will benefit from its profits.
It’s important to be aware that there are some false business moats in the marketplace, masquerading as the real thing, and you should be careful not to be taken in by these imposters.
Features like superior products, outstanding marketing strategies, and high-performance management teams are all wonderful attributes for a business to have, but on their own, they are not enough to provide a long-term competitive advantage.
Products and marketing tactics can easily be copied, and so require the presence of a deeper, more durable barrier to support and protect them from would-be thieves.
Top 5 Ways to Recognize an Effective Economic Moat
Although economic moats tend to be more qualitative than quantitative in nature, there are a number of ways you can recognize when a company has one or more in place.
A significant amount of free cash flow is common to all businesses with an effective economic moat, but here are five other factors that play a vital role in the establishment of a sustainable competitive blockade.
1. The Advantage of Lower Cost
A business that has the ability to sell its goods or services for less than its competitors will have a distinct competitive advantage in the marketplace.
Naturally, the only way to accomplish this, and still earn a profit over the long-term, is to be able to manufacture a product or provide a service at a lower cost than everyone else.
This is often the case for larger companies with the resources to “buy in bulk” or to operate more efficiently for a lower cost, and also for those types of businesses that can be effectively located close to both the source of their income, and to their customers, such as in the case of a local quarry.
When you investigate a company’s potential economic moat in terms of cost advantages, be sure that those advantages are sustainable.
Obtaining a large share of the market today by undercutting competitors at a loss, for example, is not something a business can maintain indefinitely.
2. The Advantage of Greater Size
Sometimes the sheer size of a company, in conjunction with the small size or niche-like nature of the market it serves, is enough to deter potential competitors and to serve as a wide economic moat.
When a company has a relatively exclusive monopoly, for example, it means it controls the supply of a particular product or service within a certain location or industry.
This makes it very difficult for similar companies to get a foot-hold in the same market, since the established giant in the neighborhood has already claimed most of the available customers, and has sufficient size and resources to do whatever it takes to hang onto them.
3. The Possession of Unique Assets
Sometimes companies possess one or more unique, but intangible assets that provide a natural economic moat for their continued and profitable business operation.
Examples of such assets include things like patents, a strong and widely recognizable brand name, copyrighted intellectual property, and specialized permits or other kinds of government-issued licenses.
These types of assets allow a business to charge a premium for their goods or services, because they offer customers something that’s limited, exclusive or difficult to replicate, as well as something that’s often known for having a predictable level of quality.
From an investor’s perspective, you should look for companies that are protected by the advantage of a premium brand name, a tightly licensed product, a loyal customer base, and/or an industry with extremely regulated and complex entry requirements.
4. The Benefits of the Network Effect
When a business has the built-in ability to both grow and improve as it gains more customers, it is said to benefit from the network effect.
In these cases, the more people who use a certain business, the bigger its market share gets; but more importantly, the more exclusive its hold on that share becomes.
This is simply because more users translates into a more valuable product or service for all and inherently leads to a never-ending cycle of continuous growth.
Examples of this can be seen in such companies as eBay, Visa, and Facebook. The more people who use these particular services, the better the experience becomes, which leads to more people using the services.
This competitive advantage can be difficult to dislodge once it gains momentum, and so it offers a potentially enormous economic moat to the lucky company or two that manage to establish the first successful networks in a particular industry.
5. The Ability to Command High Switching Costs
One last contributor to a company’s economic moat building lies in its ability to maintain its customer and supplier base, regardless of how fierce the competition may be.
When a company provides a customer with a product or service that is difficult to break away from, in terms of cost, time or convenience, it’s far more likely to hold onto that customer over the long-term. This scenario is seen quite commonly with cell phone plans, bank accounts, and corporate computer software programs.
Competitors must offer an extremely attractive price or performance alternative in order to entice consumers to switch from their current provider.
In many cases, customers just aren’t interested in dealing with the fees or aggravation involved in making this switch, regardless of how appealing a competitor’s offering may be.
Not only does this fact allow many businesses to maintain a strong customer base, it even makes it possible for them to incrementally raise their user prices over time, in order to consistently increase their profits.
The Bottom Line
It’s important to bear in mind that not all economic moats are created equal, and after determining whether a company truly possesses one or more in the first place, you must find a way to figure out whether their competitive edge is only temporary, or is sustainable over the long-term.