Moats in Investing

Keeping Competitors Out

Warren Buffett says," A truly great business must have an enduring "moat" that protects excellent returns on invested capital.

A company needs to do something very well in order to grow their business profitably. A moat protects a business from its competitors. It is a durable competitive advantage which keeps competitors away from the company's customers. Pat Dorsey who used to head the Morningstar is a firm advocate of moat, he feels that it is better to pay more for something which is more durable from appliances to cars to houses, items which last longer will be more expensive. The same theory applies to stock investing.

Branding

Branding is one of the most important aspects of any business, large or small, retail or B2B. An effective brand strategy gives you a major edge in increasingly competitive markets. Branding helps to build mind shares in consumers which is defined as the amount of space the company occupies in customers' minds. Tiffany has a moat. People pay alot for the box when the jewelry will be cheaper somewhere else. Coca Cola has a strong branding, the brand value in 2015 is said to be worth $83.84 billion.

Cost a lot to switch

There is not much of a competitive advantage bank has over others, their products are similar. With internet banking, branch locations has lesser impact than before. However, consumers tend to stay with one bank for average six to seven years as it is troublesome to change banks. When switching cost is high, there is a moat. Previously, iphone users would not use android phones as it was difficult to copy their contact list over to other phone and the apps are different. That was a moat. However, with more intelligent phones entering the market, the moat of iphone is slowing eroded.

Network Effects

The more users of the product, the more they will enjoy the network effects. Think Facebook, Twitter and Youtube. It is very difficult for competitors to penetrate a network moat.

Low Cost Producers & Sheer Size

Walmart has a moat. With economies of scale, Walmart can sell its products cheaper than competitors, ask for longer credit terms from suppliers which improves the cashflow while getting paid immediately from the customers. Larger companies can cement their advantages and sustain returns for longer by been more efficient in SG&A than smaller companies.

Erosion of moat

Moat is not permanent, competitors will figure out a way to acquire market shares and erode the competitive advantage. Industry stability is another factor in determining the durability of the moat. Stable industries can create sustainable value creation whereas unstable industries present substantial competitive challenges and opportunities.

Conclusion

You need to look for companies with consistent strong growth of net profit margin, this will indicate that the company has a moat. Then you need to consider what sort of competitive advantage it has and how its competitors can erode this. You can also consider the entire supply chain and where the profits flow to. This will reinforce whether the company has true moat.