The long-term success of a business is highly dependent on the competitive advantage of the business. With the changing environment, businesses ought to increase their competitive advantages to keep or increase their profitability and market share. Value investors look for companies with high economic moat and low share price and wait until the share price finally reflect the true value of the business to profit from it.
It is the nature of things that most small businesses will never be big businesses and most big business fall into mediocrity or worse. Over time, most big and powerful business grow complacent and lose their dominance and influence. Value investors constantly look for companies with degrading economic moat and stay away from investing in them.
Popularized by the value investor Warren Buffet, economic moat primarily originates from:
1. Customer Service
Companies with a high quality of customer service will have a high customer retention rate. Companies like Amazon focuses on good customer service through services like free return, free exchange, easy return policy, fast delivery, money back on lost deliveries, multiple listings, easy buying process and more. Therefore, Amazon tends to have a better competitive advantage over its rivals.
2. Quality of Product & Service
Distinguishing product is a visible competitive advantage of any companies. Apple is one of the companies focusing on this strategy. Their products are considered better than its rivals. Their flagship product, iPhone is the best phone (A bit of a bias opinion). Their smooth touchscreen, high pixel camera, easy to use software, fast, reliable, secure, and beautiful design are some of its advantages, although, those advantages are shrinking in recent days.
3. Cost of Production
Low-cost products are the primary choice during an economic downturn. Wal-mart focuses on this strategy. Their motto is “always low price.” They use their buying power to buy products at better rates from the manufacturers and offer a low price to their customers. Competitors trying to compete with Wal-Mart will have a hard time trying to match their low price and still be profitable. Wal-Mart, on the other hand, makes a small margin on each product but does more volume and covers its profit from its massive volume.
Geico is another example of a low-cost insurance company. Geico car insurance offers the lowest insurance of all insurance companies. Therefore, it is able to increase its market share year over year for decades now.
4. Patents and Trademarks
Companie’s intellectual properties are protected by patents and they use these patents to cash in for a long time. The tech companies use this method to gobble up the market share. Google (Alphabet Inc) is one of the examples of it. It has thousands of patents related to its search engine. Other companies cannot use their creation for a certain time, therefore, Google can leverage this new technology to increase their market share. Now, Google is the sole dominant on the internet search business. The internet search business is a winner take all business and the first or the best company will reap all the benefits. Therefore, patents are extremely valuable moats of any company.
5. Real-Estate Location
Food business focuses on this strategy of having their business in the prime locations. Companies like Starbucks and McDonald’s always want to be in the crowded intersections. These food businesses expect to get their walk-in customers in those crowded places. They don’t mind paying a high rent or purchase price to be in the prime locations, which actually is a good thing to investors in a long-term.
6. Share of Mind
Warren Buffet once said, “Share of Mind is more important than the share of market”. Coca-Cola is one of the companies focusing on this strategy. Their ads are focused to change the share of mind of their customers. People think happiness when they think of Coca-Cola. Their ads display only in places where people are having fun like the world cup, movie theaters, and other sporting events. People associates Coca-Cola with freshness and happiness. Ultimately, Coca-Cola will be able to increase its market share through the share of mind.
Disney is another example of this. The people’s perception of Disney company is far pleasing, satisfying and exciting than any other fun-park or media companies. Going to Disney park is every child’s dream. What better image does a company want than this?
7. Sales Volumes
Companies producing or turning over in great volume enjoy economies of scale. In general, the higher the volume the lower the cost. Therefore, a company has a better chance of maintaining or increasing the competitive advantages if they have high volume turnover. Companies like Wal-Mart have this advantage.
8. Numbers and Nature of Competitors
Business who enjoy few or no competitors have a great deal of economic moat. Some companies like utility companies enjoy this benefit. Due to the United States regulatory requirement, utility companies have a monopoly over a certain area. Although they cannot price their customers at their own will, it is a sustainable advantage for the contractual period.
Also, business like internet search, where the winner takes all enjoy a monopoly and a great competitive advantage. This is also a favorable scenario for its investors.
9. Brand Quality
Nike is a prime example of brand quality. Even though Nike is a sneaker company, they enjoy the benefit of high brand quality. Customers pay an extra premium for the products and services of the company if they perceive them as premium quality. Nike, therefore, has great pricing power. They do not lose market share when they increase the price of their products. This is one of the best competitive advantages of any company.
10. Management Quality
The likelihood of management being bright with cash and key decisions is very important to businesses. If the management is honest, smart and hardworking, this could be a great moat for any businesses. One of the question to ask yourself to evaluate the management is – Do the managers love the business or the money? If the management is prudent, the company will be great for a long time. Berkshire Hathaway is one of the examples of this.
Some companies enjoy one or more economic moats. If any company has more than a few of those competitive advantages, it is a phenomenon scenario to its investors. Although, just having these competitive advantages are not quite impressive as increasing those advantages. The wise investors prefer to invest in companies with increasing competitive advantages.