How to Identify Companies with Economic Moats?

In Economics, we are taught that companies earn no economic profit in perfect competition. On the contrary, a monopoly is able to raise price and earn excessive profit. In the real world, it is rare to see companies of either these extreme scenarios because innovations and changes are always happening. While some commodity-type businesses are able to charge a little premium from brands, there are also monopoly businesses in utilities or biotech that face regulatory limitations.

In real world, it is not unusual to see companies earning above-average returns over a meaningful period of time: Google, Starbucks, American Express, you name it. These companies have some special qualities that allow them to earn excessive returns over its peers, even in a competitive industry. Warrant Buffet has once coined a term “Economic Moat” to describe these qualities. In Pat Dorsey’s The Little Book that Builds Wealth, four qualities are identified for creating long-term competitive advantages, and here are the summary:

1. Intangible Assets

The intangible assets like brands, patents, or regulatory licenses allow companies to sell their products or services in a way their competitors cannot match.

Brands: Popular brands are not always profitable brands. A brand creates long-term competitive advantage only if it allows the company to charge a premium on its products. Whole Foods Market is a good example. Some other brands may be valuable because they make the products more recognisable (e.g. Coca-Cola), but they don’t necessarily increase the pricing power of the company.

Patent: Patents are able to prevent entrants of competitors, but they are valid only for a finite time and can possibly be challenged. Companies should benefit from economic moat with a diversified portfolio of patents and continuously innovating ability (e.g. 3M), instead of a single patent.

Regulatory Licenses: This gives company advantage only if the company does not subject to pricing regulation. Utilities businesses require approvals from authority but are also capped on pricing and therefore have limited advantage. The better kind of regulatory moat is the one created by a combination of small rules instead of a single rule that can be changed overnight.

2. Switching Costs

Switching costs are incurred by companies providing services or products that are difficult for customers to change or give up. These costs give companies power to raise the price. Cost-benefit analysis can help identify this moat. For example, changing banks may result in a slight reduction on fees, but the costs including disruption on transactions, time consumption, hassle documents preparation and the reconnections with other auto-pay systems are much higher.

3. The Network Effect

For companies benefit network effect, the value of their products or services increase as the user number grows, which is different from general commodities businesses where value is independent of users. This moat allows them to block out competitors for a long time. Facebook, UPS and American Express are examples benefit from the network effect. Once a product or service attracts more and more users, it will increases its value, attract more users, squeeze out smaller networks and expand in size. Some becomes the standard of the industry. This moat can usually be found on business sharing user information or connecting people together.

4. Cost Advantages

Companies with cost advantages can offer products or services at costs lower than their competitors. While some sources of cost advantages are not durable (like moving plants to China which can be followed by competitors), advantages from cheaper processes, better location and unique assets can be long-lasting.

Unique Assets: This can benefit even commodity-type business. For example, a high-quality gold mine asset can be a long-lasting advantage for a company.

Scale: Large scale in distribution is extremely hard to copy by competitors. Larger scale in manufacturing can sometimes benefit company by reducing per-unit fixed cost and specialising on tasks. Companies can also benefit from dominating a niche market that can only support one company (e.g. Airports).

As an investor, identifying these moats can help you find companies with potentials to earn above-average profit. However, these moats are not long-lasting and can be eroded by technological change, customer-base change or mistaken managerial decisions. Also, even a company is good enough with various economic moats, paying too high a price for it can be unfavourable. Make wise decisions, and you can benefit from the good businesses with economic moats.