Warren Buffet, the American businessman, investor, and the world’s richest man at multiple points over the years, coined the term ‘economic moat.’ When one of the most prominent financial wizards of the past century comes up with a term, everyone listens. So, how do we define economic moat?
When a company holds a significant competitive edge over its rivals which helps them stay sustainably profitable and protect its share of the market, that company is said to have an economic moat. This edge could be anything from a patent to a brand name.
Pharmaceutical companies are an excellent example of companies with an economic moat as they usually hold many licenses to widely-used medications.
Importance of understanding economic moat:
Now that the question ‘what is economic moat’ is answered let’s take a look at how evaluating or even following a company’s economic moat can benefit you as an investor.
It is essential to understand and identify companies with an economic moat because just like blue-chip companies, these companies are highly reliable performers on the stock market. You can strengthen your investment portfolio by investing in companies with wide economic moats.
Just like an investor, a company also needs to understand and build an economic moat for itself to remain relevant and profitable for a long time to come. It needs to be able to provide a product or service that is better than the existing or potential new competition or risk losing or reducing its market share.
Creating an economic moat:
There are certain qualities or sources that can build an economic moat for a company. A company can have more than one of these qualities. The wider the economic moat, the stronger is the company’s competitive edge.
The following are the attributes or sources that can build an economic moat for a company:
1. Cost advantage
Think about a company like Wal-Mart or Jio. Their most significant advantage is the price at which they sell their products and services. They can easily offer a price that is lower than their closest competitor. Even if a new player enters the same market segment, these companies can offer an amount that the consumer cannot resist. As for the other companies with a similar offering, they cannot afford to put a price tag as low as the Wal-Marts of the world due to several issues.
2. Network effect
Take e-commerce shopping sites such as Flipkart or eBay. The value of the services they offer- buying and selling- depends on the number and quality of users. If there are more buyers, there will be more sellers, and if there are more sellers, more buyers will find what they want. It’s a case of ‘the more, the merrier’.
3. Switching costs
Let’s say you want to move from one home wi-fi provider to another because of poor connectivity. However, you realise that you will have to pay a hefty installation and service fee to switch to another internet provider. This means that there is a high switching cost attached to wanting to move from one company to another. Companies such as telecommunication and IT often have high switching costs which result in higher customer retention.
4. Intangible assets
As mentioned earlier, patents, licenses, or rights to intellectual property are some of the intangible assets owned by the company which ensures that either competition is non-existent, or the nearest competitor cannot offer as good a product or service in comparison. A classic example is a pharmaceutical company manufacturing drugs for cancer treatment. Most pharmaceutical companies hold on to the patent and become the sole manufacturers of much-needed medicine. Hence, there is no competition as they hold licenses.
5. Efficient scale
Let’s say a particular geographical area is rich in coal, and a couple of companies already have established their capital- intensive operations to mine the coal. Now, in such a niche market with existing players, and high costs of establishing a footing, it would be nearly impossible for anyone else to build a business there and still be profitable.
If you are inspired by Warren Buffet’s journey and his belief in the concept of an economic moat, call up your broker right away to figure out your next investment.
