Why Moats Matter to Equity Investors

By: Tim Bennett
A “wide economic moat” is what separates successful firms from their rivals, according to US investor Warren Buffett. Here’s a snapshot of how they work.

Successfully picking stocks requires a number of skills to be deployed;

  • Analysing profitability, financial strength and cash flow
  • Assessing the track record and expertise of management
  • Judging whether a firm has a sustainable, competitive advantage
  • The third of these is where we are focusing this time. Warren Buffett once encapsulated the concept by saying that successful firms have “wide economic moats” – but what did he mean?

How firms build wide moats

If a firm is going to thrive and see off its competitors over the long-term, it needs to be able to demonstrate four characteristics;

  • Cost advantage
  • The “network effect”
  • Barriers to entry
  • High switching costs

Much has been written on each by a host of commentators over the years, so here is a quick snapshot. Please contact an Investment Manager if you would like to know more.

Cost advantage

In a nutshell, a firm needs to find a way to do what it does better than any competitor but also at a lower cost. That way it will achieve sector-winning sales but also generate decent profits from those sales. The issue is how. There are a number of possible answers, which range from the smarter application of technology, running a tighter supply chain and/or simply having better control over key inputs such as raw materials and/or labour costs. Ideally a firm will combine all of these together to maintain its cost advantage.

The "network effect"

The most successful social media firms can be a great example of the “big is beautiful” rule. By gaining traction quickly amongst consumers, firms can build a valuable network that then expands as more and more people want to join it. Later they face a new challenge of how best to monetise what they do but they will not get to that stage unless they get first-mover advantage and hang onto it. Creating that network effect isn’t easy but can come, via say an online platform, from offering unique features, ease-of-use, loyalty benefits and/or greater intelligence when it comes to processing customer inputs and responses.

Barriers to entry

Some firms have business models that are difficult to copy and compete with. The reasons vary from a high demand for capital (think of oil and gas exploration), a regulatory hurdle (such as the need to get a license to bring a product to market) and/or control over key intangible assets (think of star footballers in the context of football clubs). These advantages can be quickly lost when, for example, regulators act to reduce a firm’s control over a particular market, or technology shifts the way a product is produced, so investors need to actively monitor this aspect of a firm’s moat.

High switching costs

“The best a man can get” is a famous tagline for a well-known brand of razor. It reflects that brand’s desire to create “stickiness” to dissuade savers from switching to a competitor. The product itself can be differentiated by adding more blades, lubricant, better packaging, a swivelling head and so on. Gaming companies are another example – there have even been recent legal accusations that some online games are made to be deliberately addictive. Interconnectivity is another aspect of this – the classic example is Apple’s dominance thanks to its ownership of the operating system and hardware needed to enjoy its products – without one the other is pointless and there is no obvious way to switch either component without dumping the entire brand.

If you would like to discuss the strength of the moats around some of the stocks in your portfolio, please contact an Investment Manager.