5 economic moats I look for in a company before investing

“In business, I look for economic castles protected by
unbreachable ‘moats’.” – Warren Buffett

Warren Buffett popularized the term “economic moats”, defining it as a business’s ability to sustain competitive advantages in its industry. This article delves into the details of his definition with examples of familiar companies for context.

In medieval times, moats were designed to protect castles, it was what deterred or hampered invasions. Reapplying and modifying this definition to a corporate finance context simply means that the castle would be the firm, the moat would be its competitive advantage, and the invaders would be their competitors.

Not all firms have moats, but “moatless” firms aren’t necessarily bad investments that will disappear over time. Moats simply give a firm a type (or a combination) of competitive advantage that competitors either find it hard to copy or incredibly expensive, or sometimes downright impossible to compete with.

Some of these competitive advantages are:

1. Switching Costs

A firm with a domineering position within its industry can build up a moat by charging its customers high switching costs, deterring them from going to their competitors. Not all switching costs can be considered a moat. Here’s an example: the penalties for prematurely terminating your telco contract is a switching cost and it gives the telco a (usually) two-year stranglehold of cash flows from you. Consider the three telcos in Singapore: none have moats as all three have similar switching costs, and once your contract is up, you can freely choose to subscribe with another telco. This is not a moat.

Switching costs may not necessarily mean monetary costs as it includes intangible costs as well. Apple’s an excellent example of this – its ecosystem is their high switching cost. Any user of an iPhone, iPod Touch or iPad would know that only iTunes would work with their devices, as well as iCloud for syncing all apps and data amongst devices. For an iPhone user to switch to another phone system, the cost will be high in a sense that it would be a waste of time setting up everything from scratch like updating music playlists song by song and downloading apps all over again. Inconvenience is the switching cost in this context. Furthermore, Apple went a step further and introduced with iOS9 an Android app that will seamlessly transfer data from an Android phone to an iPhone, which is also a type of moat-widening strategy Apple employs to strengthen its market share.

Another intangible switching cost would also be education. A software company that dominates a field in enterprise software can educate users, enticing them to use their software over others. If an engineer or designer were to switch to another software, he would have to re-learn everything and that costs time and money. A company with such a moat would be able to price their products at a premium and earn excess profits from its user base. Case in point: Adobe Photoshop.

2. Regulations

Government regulations can create or destroy moats with just a pen. It’s one of the most powerful types of moats out there as the regulators are the ones controlling the barriers to entry. Using a Singapore context, two local companies have regulatory moats, but both have slightly different characteristics.

SGX is the only stock exchange in Singapore and it also plays a dual role of being the regulator of our local stock market. This gives it the widest possible moat: being both the player AND the regulator. The nature and size of our market itself deters incoming competitors. New entrants to our markets would find it expensive to spend on building an infrastructure to support a new stock exchange engine, and is also at the mercy of SGX being the regulator.

One hallmark of a company with a wide moat would be huge profit margins. SGX has a net profit margin in excess of 40%, so does Apple with profit margins above 30%.

Regulations play a different role on VICOM wherein their income is impacted by regulations on cars – and not on the company itself. This creates a moat for VICOM as law dictates that all vehicles must be tested and inspected regularly; giving VICOM recurring income. Their well-located vehicle inspection and testing facilities around Singapore run a near-monopoly on this market. Complemented with their brand recognition, VICOM has a competitive advantage in the local vehicular inspection market.

How a change of regulations might affect VICOM would be something as simple as a change in the frequency of inspections for cars that will directly impact cash flow for VICOM.

3. Patents

Intellectual property protection can come in the form of patents. This holds true in an American context whereby American companies tend to be more innovative and operate in a litigious environment. Technology and pharmaceutical companies are more inclined to protect their creations with patents.

Consider Gilead Sciences, an American pharmaceutical company that recently patented two blockbuster drugs that treat patients infected with hepatitis C – Harvoni and Sovaldi. With hundreds of millions of hepatitis C-infected patients globally, these two drugs once patented would provide Gilead Sciences with massive cash flows hat no other competitor can create as it’s protected by law.

The patent protection on those two drugs would be considered an economic moat for Gilead as competitors can’t mimic the same drugs and sell them without being sued.

A company’s moat in this context may be eroded when a blockbuster patent expires, sometimes called a “patent cliff”, whereby generic drug-makers would then be able to copy, reproduce and sell the drug at a much cheaper price, completely saturating the market. To keep an economic moat like this wide, a company must have a cutting edge and an innovative research and development department to keep churning out new successful products, or simply buy out companies with successful, patented innovations.

Valeant is such a company – their strategy is not to use millions of dollars in R&D but instead use it to buy out smaller companies that produce potentially high-cash flow products. A recent example was .

4. Cost efficiencies

A moat in cost is a competitive advantage a firm can strive to achieve. Undercutting competitors while making a profit doing so is the crux of a company with such a moat. GEICO is an example of a cost efficient insurer. GEICO’s moat was spotted by Buffett and then exploited further once it was integrated within Berkshire. By concentrating more on spending on advertising than on agents’ commissions, they have significantly reduced expenses. This gave GEICO further leeway in reducing premiums for its customers, undercutting the competition and as a result, becoming the U.S.’s second largest auto-insurer in 2013.

As mentioned in my earlier article on insurance comapnies, expenses affect underwriting profits and insurers can’t totally control their losses, particularly in the P&C (Property and Casualty) insurance industry but they can control their expenses. GEICO suppressed their expenses greatly to give itself a margin of safety to reduce premiums. No other auto-insurer copied GEICO’s strategy as they might start to incur underwriting losses due to high expenses on their staff.

5. Network effect

This is commonly seen in internet companies such as Facebook, Twitter, Instagram, Snapchat, Airbnb, Alibaba, eBay, Amazon and the likes. Value is placed on the sheer volume of users of said service, and if a company can monetize their users, they’d achieve an economic moat in its network.

Using Facebook as an example, as more and more people use it, they abandon older or less attractive platforms to join Facebook due to peer or environmental pressure. Competitors would then find it difficult to entice existing users of Facebook to use their services due to the fact that all their friends, co-workers or family are on Facebook. The network effect for Facebook is so strong that it currently has over a billion active users. Facebook has since seen its profits explode after it successfully monetized its users, and like a typical large-moat company, its profit margins are in excess of 30%.

Similar network effects are evident in WhatsApp and Instagram, of which Facebook acquired to perhaps integrate into their business model or to find more ways to tailor-make advertisements to further monetize their users. It thus can be argued that Facebook has a moat that is tough to break up due to its sheer size.

How to identify moats in your investments

Companies that have high returns on capital over its cost of capital for a lengthy period of time may exhibit ”large-moat” qualities that an investor might be inclined to investigate further. Sometimes, obvious signs like a monopoly-like business can indicate a moat. Excess profits, huge profit margins, and relative outperformance to industry peers are classic signs of a company with a moat.

However, moats do not last forever. People change, governments change, and laws change. Competition is always out there and people are naturally inclined to enter an industry if they see a firm making excess profits; they want a slice of the pie as well. If a firm with existing dominance in market share (i.e. Nokia) remains ignorant of the creative destructiveness of capitalism, its moat would slowly be chipped away and eventually the economic castle will burn. The market punishes the firm by pushing its stock price down and rewards the newcomer lavishly.

Buying firms with wide economic moats sounds good on paper, but you’re probably not the only one in the world to have figured this out; companies with huge moats tend to be trading at premium prices as the market rewards it for its financial and operational outperformance.

Using a margin of safety to invest or simply having the patience to wait for market irrationality to hammer a high-quality firm’s stock prices down would yield better results than jumping in immediately and hoping the company’s moat stays intact for the length of your investment.