I apologize for not posting recently, my school has been hectic. Recently, I have been learning about one very interesting concept, competitive advantage. Competitive advantage is a way to identify which company has the advantage over the other, pretty simple. This concept is very, very important in investing, it helps separate good stocks from bad ones.
A company’s competitive advantage is often called a moat. This is an analogy. The castle, in this analogy, is the business itself and the moat is the competitive advantage of the company. The moat protects the castle from outside attackers, or in this case, other competing businesses. The moat is a way investors identify the advantage one business has over the other. In this post, I will be talking about the different types of moats and how that can be beneficial to an investor. According to Morningstar, there are five different types of moats, Intangible Assets, Customer Switching Cost, Cost Advantage, Network Effect, and Efficient Scale.
Before we dive in I would like to mention the importance of a moat. Like I said, a moat is what protects one business from being overthrown by another. It is what makes consumers pick your product of the self instead of another. Although, it is a somewhat easy concept to grasp many business owners forget. In fact, 80% of new businesses fail within the first 18 months because they lack a moat.
First, one of the more common moats is Intangible Assets. This means the company has either patents protecting a service or product so it cannot be copied or a well known brand. For example, Coca-Cola (KO). People have been drinking Coca-Cola for around 120 years and still enjoy it. They have the brand and the name so well established that it will be nearly impossible for another company to overthrow them. And when they had an “oopsie” changing the flavor of their drink, they recovered somewhat quickly because people remembered their brand.
Customer Switching Cost
Next, Customer Switching Cost. It means that leaving one company and switching to another would make a great inconvenience for the consumer or customer. This discourages many customers from switching, unless there is a benefit of some sort like an improvement in price or performance of the product or service. For example, growing up in the 21st century the biggest decision I’ve had to make is a Android or Apple phone. It is very difficult for some people to switch services because of the different software and hardware and it doesn’t transfer as smoothly. Normally, once a customer decides their phone provider, they stick with it.
Thirdly, there is Cost Advantage. This something that is very noticeable in one company, in particular, Amazon (AMZN). Because of their low prices and speedy delivery people prefer to order from them making other companies struggle. I have watched a number of Barnes and Nobles (BKS) disappear from the Twin Cities because of Amazon competition. Consumers, for the most part, look for the cheaper option of a product or service making it harder and harder for other companies to match it. For example, when you’re at the grocery store and picking out ice cream. Well, many companies have cookies and cream ice cream then becomes a matter of which is cheaper. Consumer almost always go for the cheaper option.
Now, this doesn’t always apply. Quickly looking back at Intangible Assets, once you have a few, well known brand established people would be willing to pay much more. An easy example of times when Intangible Assets beat Cost Advantage is Tiffany & Co (TIF). Customers are willing to pay 30% more for a Tiffany diamond rather than another branded diamond that is cheaper.
Next is the Network Effect moat. The Network Effect is when there is more demand for the product and so the value increases making it more accessible to others. This definition, I know, is a little confusing but the example might clear it up. Looking at Mastercard (MA) or Visa (V) or almost any other credit card company there is, what happens is this cycle. More people get Mastercard or Visa so more merchants have to accept and when more stores accept it more people become cardholders. It’s just one large circle of supply and demand. Another example is social media, like Facebook. The more people post, the more people join. Putting it simply, stronger companies get stronger.
Normally, when the supply and demand cycle happens it washes away smaller companies, leaving a few larger, more powerful companies. This is the last moat called Efficient Scale. That means that there is a market that is controlled by one or a few major companies. It limits other companies to try and enter the field and makes great competitive prices for the few existing companies. For example, if BNSF Railway (BRK.B) wanted to build a railroad from Minnesota to North Dakota to carry coal it would not benefit another company to come and build a parallel railway to ship the same product.
This moat doesn’t apply for all types of markets. For example, the food market. If we are looking at Chipotle (CMG) or McDonald's (MCD) I may change my opinion of which restaurant I want to go to every day giving both companies money. Rather than with a railroad company, you have to pick which one you want to provide the state with coal.
This list of moats should become a second language to you. It is very important to think about when you’re trying to identify good stocks. The larger the moat, the less risky the stock is. Not only is it very beneficial to investors, but it’s fun to just think about. Like if there are two stores across the street which one will last longer because of their competitive advantage? I hope this will help with your investing thought process.
You should look for companies with larger moats but be prepared to pay a little extra for them. It is better to pay more for a good or great company with a moat than paying cheaply for a bad company. I will list all the companies with their metrics below.
Price to Earnings Ratio
Return on Equity
BNSF Railway (BRK.B)
Tiffany & Co (TIF)
Barnes and Noble (BKS)