Moats

The Key to Sustainable Investing Success

May 17, 2023

Warren Buffett came up with the economic moat concept in investing. Some say competitive advantage, unique selling point, or some other word that explains a company’s ability to protect its market share and profits.

“The most important thing in evaluating businesses is figuring out how big the moat is around the business,”

Warren Buffett

This makes it important to understand the concept of "moats" is essential for investors seeking sustainable long-term growth. Just as a castle's moat protects it from invaders, a company's moat shields it from competitive threats. In this article, we will explore what moats are, why they matter, and delve into different types of moats according to Morningstar, authors of the book “Why Moats Matter.” I have previously written about Porter's Power Model - A Model to Find Moats which can help you recognize company moats.

What is Moats?

In short, an aspect of the business that makes the company defend its market share and profits. In investing terms, it refers to a sustainable competitive advantage over its rivals. When assessing a company's long-term viability and growth prospects, it is essential for investors to understand the competitive advantage. An investor must also remember it is not only the direct competition the moat needs to protect the company but also against substitutions, new entrants to the market, suppliers, and customers. All of these actors can hurt the market share or the profit margins in different ways. A robust moat enables a company to generate superior profits, defend its market share, and enjoy pricing power over its competitors.

Why Moats Matter

Moats matter in three main ways:

Long-Term Profitability
Companies with strong moats tend to enjoy stable and consistent profitability, making them attractive investment options. A well-protected moat creates barriers for new entrants, reducing the risk of disruptive competition and preserving market dominance.
Economic Moats Drive Shareholder Value
A company with a solid moat can deliver superior returns to its shareholders over the long run. Such businesses possess pricing power, enabling them to command higher margins and generate substantial cash flows, which can be reinvested or distributed to shareholders.
Reduced Business Risks
Moats act as a buffer against market volatility and economic downturns. By mitigating competitive pressures, companies with strong moats are better equipped to endure challenging times, making them more resilient investments.

So with a moat, will the revenue and profits be protected, and the company will create shareholder value over a long time with a reduced risk for the business. This is what a long-term investor a looking for, especially when focusing on quality companies.

Moats, according to Morningstar:

Intangible Assets
Some companies possess intangible assets, such as patents, copyrights, trademarks, or strong brand recognition, which act as moats. These assets create high entry barriers for competitors, as they cannot replicate the company's brand image, customer loyalty, or unique intellectual property.
Switching Costs
Companies that have a strong hold on their customers due to high switching costs enjoy a formidable moat. Examples include software companies with complex products or services requiring substantial time, effort, or financial resources to switch to competitors.
Network Effects
The network effects can be a powerful moat in industries like technology, social media, or online marketplaces; as more users join a network, its value increases, creating a virtuous cycle that reinforces the company's dominant position.
Cost Advantages
Companies with cost advantages, whether due to economies of scale, unique production processes, or access to scarce resources, can maintain a competitive edge over rivals. This moat makes it difficult for competitors to match the company's cost structure and thus erodes its profitability.
Efficient Scale
Companies that operate in industries where significant economies of scale can be achieved possess an efficient scale moat. These businesses enjoy cost advantages as they grow and expand, making it challenging for competitors to catch up.

Companies with moats

To exemplify, let’s see some companies which have these moats.

Intangible assets

Intangible assets are the oldest and most robust form of moats. One prime example is patents, which effectively block out competition. While there may be ways to circumvent them, patented intellectual property (IP) offers substantial protection. IPs can take the form of characters, molecules, trademarks, designs, and more.

Take, for instance, the beloved character "Steam Boat Willie Mickey Mouse." This iconic creation has enjoyed exclusive protection from global usage for decades, with its copyright slated to enter the public domain in 2024. Companies like Disney, Nintendo, Embracer, and others in the entertainment industry exemplify the power of intangible assets as moats.

Similarly, luxury companies such as LVMH showcase the strength of brands as intangible moats. Having developed their brand over a span of 100 years, competitors would require an equally lengthy period to catch up.

Switching costs

Software companies, particularly in the case of ERP systems like SAP, exemplify the significant impact of switching costs. Switching from one ERP system to another entails immense costs and challenges. Drawing from my experience as an accountant and controller, I can attest that no one desires to undergo the arduous process of changing an ERP system.

The complexities involved in relearning a new system, integrating various other systems, and updating files for analysis create a substantial deterrent, particularly within the finance department. While finance may be considered a support function, the ability to operate smoothly and efficiently is paramount for cost tracking and informed decision-making. The potential benefits of a well-functioning ERP system are relatively low, but the consequences of disruption or inefficiency are enormous.

Network effect

Ebay and Hemnet serve as prime examples of how network effects drive the success of their business models. These platforms experience an increased value proposition for both users and merchants as the number of participants grows.

With more users joining the platform, the network effect amplifies, resulting in enhanced benefits and advantages. As the user base expands, the attractiveness of the platform increases, fostering a virtuous cycle that attracts even more users and merchants. This, in turn, leads to a higher volume of transactions and a greater variety of goods and services available, ultimately creating a thriving ecosystem.

The power of network effects lies in the ability to create a mutually beneficial environment where the platform gains value from the growing number of participants while users and merchants benefit from the expanded reach and opportunities provided by a larger network.

Cost Advantages

Achieving cost-effectiveness serves as a powerful strategy to deter competition, as rivals find it difficult to match the price and struggle to attain profitability. Walmart and Costco exemplify this approach by leveraging their scale and purchasing power to offer competitive prices.

These retail giants capitalize on their size and ability to buy in bulk, enabling them to negotiate favorable pricing from suppliers. Consequently, they can pass on these cost savings to customers, offering lower prices than their competitors. This price advantage acts as a formidable barrier, making it challenging for rivals to match their affordability.

By maintaining a cost-effective approach, companies like Walmart and Costco solidify their market positions and enjoy sustained profitability. Their ability to deliver value through competitive pricing attracts customers. It keeps potential competitors at bay, as replicating their cost structure and achieving similar economies of scale becomes an uphill battle.

Efficient Scale

Evolution Group enjoys notable efficient scale advantages, placing it in a formidable position. Competitors face substantial financial hurdles in establishing studios, particularly due to the requirements set by US regulations in certain states. These regulations mandate the presence of in-state studios for offering live casino games.

Evolution's scale empowers them to make significant investments in these studios. Their established infrastructure and resources allow them to meet regulatory demands, ensuring compliance and expanding their reach. In contrast, due to the associated costs, competitors find it challenging to replicate these investments and establish their own studios.

The efficient scale advantage held by Evolution becomes a crucial moat, as it creates a barrier to entry for competitors in the live casino game market. Their ability to invest in and operate studios gives them a unique position, setting them apart from rivals who struggle to match their capabilities.

Conclusion

Moats are critical considerations for investors looking for long-term value and growth potential in the financial markets. Identifying companies with sustainable competitive advantages allows investors to make informed decisions, reduce risks, and potentially benefit from superior returns over time. According to Morningstar, investors can evaluate companies and build a well-diversified portfolio that incorporates businesses with robust defenses against the competition by understanding the different types of moats. Remember, investing in companies with strong moats can provide a solid foundation for your financial success.

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