Learning Resources

5 Economic Moats to Up Your Investing Game

01 Mar 2022

5 Economic Moats to Up Your Investing Game | VI
(c) Sadie Xiao

A business defending itself from other competitors... you would imagine tall walls, cannons, soldiers, and most noticeably, a large moat.

The term "moat" refers to the first line of defence surrounding a castle or a territory. Historically, castles are built encircled by a water-filled trench. This body of water defends the castle from attacks. The larger the moat, the less likely attackers will be able to cross and invade the castle.

So, what do defending and attacking castles have anything to do with businesses and investments?

Well, a castle is just like a business. The “moat” or “economic moat” acts as the business’s first line of defence against its competitors.

You can also think about it as the unique durable advantage a business has which protects its profitability and its market share.

But why are economic moats important in stock investing?

Why learn about economic moats

When deciding on which company to invest in, you can think of companies as castles. Defending a castle with a wider moat is sure to be easier compared to a castle with a narrow moat.

When we look to invest in a company for the long term, we need to find one with a strong economic moat so it will not easily be overtaken by its competitors in the next ten years or so.

Observe the successful companies you know of. Don’t you think their customers have a reason to choose their products or services over other companies? This means they have an economic moat that helps them secure this market share.

Who wouldn’t want to invest in a company like that, given, of course, that the other fundamentals are similarly stable? It follows that such companies could generate considerable long-term and increasing cash flows to help fund their day-to-day operations.

There are different types of moats that a business can have. Look out for any of these moats in the companies you want to invest in, and you’re sure to up your investing game.

Types of economic moats

The best businesses usually have several economic moats.

Companies do not, however, need many economic moats to retain a unique competitive advantage over their competitors. In fact, a company only requires one strong economic moat to maintain a distinct edge over its competitors.

Here are 5 types of economic moats you should be aware of.

1. Network effect

Network Effect Economic Moat | VI

Remember what they say about ‘your network is your net worth’? It’s related to businesses, too!

The network effect is one of the most powerful moats a company could have. This moat refers to when the company’s value increases as more and more people use it.

For example, Amazon has an apparent network effect moat as seen in its impact on the e-commerce marketplace. Buyers and sellers are brought together in this one platform, which inevitably creates a domino effect that further increases Amazon’s profitability.

Because most suppliers and customers are on Amazon, the company offers lower prices, which then attracts more customers, thereby, attracting more sellers. Powerful, isn’t it?

Google also has a network effect moat in terms of data. Until today, even if a lot of other search engines exist, we intuitively use Google to do web searches. And the more people use Google, the more companies, websites, and data providers use this same search engine to reach their target audiences.

If you still haven’t absorbed how powerful the network effect moat is, just look at Facebook. This social media platform has a growing network of users that its value also increases as time goes by. Today, Facebook is hailed as one of the fastest-growing tech companies.

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2. Intangible Assets

Intangible assets are non-physical assets that provide a business with a competitive edge. This can include having patents, regulatory licenses and government approvals, brands, and copyrights. And we’re pretty sure you know where we’re going with this.

Yes, having this moat secures a company’s position in an industry and allows it to charge more for its products and services.

For example, Starbucks as a brand is so popular around the world, that it can increase your willingness as a customer to pay more for a simple cup of coffee (that probably tastes the same as your regular kopi). Customers pay for the brand value more than the product.

The same goes for Nike. As the most popular sports brand, Nike can easily overtake its competitors, charge premium and still get more customers to buy its products.

In the same way, patents and regulatory licences provide a strong moat, especially when a business is within the healthcare industry.

3. Cost advantage

Cost Advantage Economic Moat | VI

Selling products for less than $10 when other retailers are selling them for $15… who else can do that but companies such as Walmart?

Walmart is the best example of a business with this kind of moat – cost advantage. Because of the large number of its stores and the overall size of its network, it can afford to sell cheaper products. Walmart can even kick out new competitors attempting to enter the market using this same moat.

How did Walmart achieve a cost advantage moat? It shifted to centralising the whole company. So instead of individual stores negotiating with their respective suppliers, Walmart can buy supplies in bulk, hence, incurring cheaper costs. It then follows that its products can be priced lower as compared to other stores that cannot negotiate the same price with suppliers.

4. Switching Cost

Switching Cost Economic Moat | VI

If you’re using Apple or Microsoft, switching to a different service is a hassle. And oftentimes, we stick to using these brands because it’s more tasking and expensive to switch to another brand. It’s not good news for consumers, but it is a great competitive advantage for businesses.

This is called the switching cost moat. It’s when a company's services restrict you in a way that transferring to a different provider becomes more expensive or time-consuming.

Think about the bank you’re using. If you wish to change to another bank tomorrow, how easy would it be for you? The cost and the paperwork would be unthinkable!

The same goes for operating systems (OS). It would be too much of a hassle for you to change OS every now and then, that in the end, you’ll just opt to continue subscribing and using one over the other.

This is the switching cost moat. Businesses would want to have this kind of moat as it will secure them a fair market share and ensure their profitability.

5. Efficient scale

Who doesn’t want to be in an industry where competition is low? Companies with efficient scale moat enjoy this.

For example, Lockheed Martin operates in the aerospace industry. Its customers, usually governments, purchase defence equipment and weapon systems from LMT. This market size is so small, plus the procurement of equipment follows certain regulations, i.e., US allies may only be allowed to buy from a US supplier. This way, it becomes extremely difficult for other competitors to enter the same market.

There are other economic moats a company can have, but the five above are the strongest ones that you could look into when thinking to invest in a business.

To learn more about how to identify stocks with a wide moat and other important fundamentals, come to our free two-hour masterclass.

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