Warren Buffet uses the analogy of a moat or deep water-filled channels which were used to surround castles during the medieval era. These moats protected the castles from invasions and attacks as it would be difficult to storm castles having wider and deeper moats.
Here, the moat is referred to a company having the position of a sustainable and competitive advantage, which allows the company to earn greater ROE over cost of capital and higher profits and surpass its competition in the long run. Companies having a wide economic moat are said to be able to survive for long periods and consistently earn higher returns on capital invested. It also enables these companies to sail through stormy weather and battle through difficult economic periods and market conditions. Many companies are known to have more than one moat which gives them an additional edge over its competitors.
However, very few companies can boast having a competitive advantage, and even fewer companies can pride themselves having a sustainable competitive advantage
How do we know what is a MOAT for a particular company?
There are basically a few sources of MOAT that a firm can put on with pride.
A company would like to place its retail outlets at the perfect location in any city for it to be easily accessible, convenient for its customers to approach and also should be spotted immediately, in short there should be a high number of footfalls in that store. Let us take an example of the fast food chain, McDonald’s. McDonald’s has placed its outlets at all prominent and busy places in a city. It could be Malls or petrol pumps on the highway for refreshments or even outside local railway stations. This will bring up a challenge for its competitors to open a store next to them at every location which would be humongous for any competitor. This acts like a MOAT to McDonald’s which would help them to survive in the long run by generating higher profits from each outlet.
Costing plays a vital role in any business. Lower the cost, higher the profits a business would earn.
I would like to split up this MOAT into three different sections-
First let’s talk about process-based costing - If the production process is efficient then the costing per product would reduce drastically, which in turn would result in better margins for the company compared to its competitors with not so efficient processes, which would be definitely be a MOAT.
Second one which I would like to point out here is a location-based cost advantage. If a company could gain by strategically choosing their geographical location it would reduce costs & would become a MOAT. Let’s take an example of a company which produces paper. The main raw material of paper is wood & the company would save a lot of transportation cost if their manufacturing plant is placed close to the forest area where the trees are being cut for the wood. The company would improve their margins drastically, which in turn will increase their profits and returns, thus would build a MOAT for themselves.
The third MOAT would be scale based; larger the scale of production lower would be the cost per unit produced. China is the best example we could take here. How does china produce its product at such a lower price? The answer to this is they produce in large volumes; hence the fixed cost gets distributed amongst a greater number of products which will reduce their costing, resulting in increased margin than its peers and hence it would act as a MOAT.
Another MOAT would be the purchasing power – larger the scale of the manufacturing unit better the purchasing power. Raw material can be purchased at a much lower price due to large volumes, thereby reducing the cost of the finished goods. An example of this would be D-mart. Since they can purchase very large volumes, they can pass over huge discounts to the consumer.
A company should have large distribution network in order to have a wider reach in the country which will help them to get a grassroot level of feedback about their business performance. It is not as easy as it is said, it takes decades to build a cobweb type of network. A company can do so by having their own stores (e.g. D-mart), franchises, distribution agents or even multi distributor store. Having a large distribution helps a firm to beat its competition in all aspect. Higher distribution means large volumes to penetrate in both urban and rural areas, larger volume leads to lower costing and in the end leading to good margins for the company. In the future if the company would like to like to launch a new segment to compete with peers or even to enter into a new sector, it already has a wide distribution network to knock off others in the industry. ITC would be a great example for this, it has hands in many segments like FMCG cigarettes, FMCG others, paper and packaging etc. ITC would have used their large network to grow in all the segments they are present in. This becomes a very difficult MOAT to be overcome by the peers.
Pricing power can be explained as the extent to which a company may raise prices without reducing demand for its products. A company having a good pricing power in the industry beats the competition in the market. Even this is a type of MOAT which takes a lot of time to build and maintain it. Pricing power could be achieved by a company in several ways like brand, loyal customers, product quality, best in class customer service etc. Amul in its milk segment has a very good pricing power, they have consistently increased their prices over the last 10 years ( The milk prices have been hiked 88% in the past 10 years from 24/litre to 45/litre) despite of this they have not lost their market share, in fact they have increased the sales turnover by a whopping 312% (from 17000 million to 70000 million). This shows the strength and power of the company of increasing the returns by increasing the price and not even losing their customer base.
Switching cost is the cost that a customer has to bear upon changing its preference in terms of brand or a company. Higher the switching cost better it is for the company as the customer won’t change over to another company. Suppose an airline operates only on Airbus aircrafts, they must have trained all their pilots, ground staff, cabin crew according to the procedure one should follow in Airbus aircrafts and also would have a standard technical SOP’s. The same airline wouldn’t change over to Boeing aircrafts due to the high cost they would incur in training all the staff and pilots and also to install new software for the same. This gives us an idea of how high switching cost protected Airbus of not loosing the airline to its competition.
Intangible assets are one of the primary sources of strong competitive advantages for businesses and a key source of economic moats. Intangible assets can include corporate intellectual property, such as patents, trademarks, copyrights, government licenses, and business methodologies. Intangible assets help companies to safeguard key competitive advantages. Companies can use patents, for instance, to protect inventions from unauthorized commercial usage by competitors. Like patents, government licenses also raise the entry hurdles for new competitors. For e.g. pharmaceutical companies get a patent on their new formulation for a period of a couple of decades in which only they would be able to sell that drug at the price determined by them, even after the patent expiration other companies would not be able to use the same name but could launch similar generic medication.