How to Identify an Economic Moat
As a long-term value investor, one of the most essential parts of the analysis process is to identify the economic moat of a company. The term "economic moat" was coined by Warren Buffet. It refers to a castle and how it's surrounded by a deep trench filled with water, a moat. The bigger the moat, the harder the attackers could get across to the castle. That's why if you're a long-term value investor, you should look for companies with a strong economic moat, a distinct and sustainable competitive advantage.
In this week's ONE THING, I'm going to share with you the 7 types of economic moats with examples of companies that have them.
7 Types of Economic Moat
- Network Effect Moats: The network effect is when a company's products/services become more valuable as more people use them. As more people use the products/services, they become more valuable, leading to even more people interested in using them. Social media platforms like Facebook, YouTube and marketplaces like Amazon hold value because many people actively use these platforms
- Intangible Asset Moats: Non-physical assets or attributes a company has that gives them an advantage. It could be a strong brand name where people use it in everyday language like "just Google it" or "Photoshop it" or it could be a trade secret like the secret formula to Coca-Cola or the secret ingredients to KFC's fried chicken
- Switching Cost Moats: This is when a company's products/services lock a customer in and make it so that switching to an alternative is just too expensive and not worth the time. A good example would be Apple. Try convincing an Apple user to switch over to Android (Read about Apple's Walled Garden on last week's issue)
- Economies of Scale Moats: This is when a business usually due to its size, has a cost advantage when supplying materials or adapting to changes in demand. We can look at a company like TSM, the largest semiconductor foundry in the world. Starting a foundry is a capital intensive business, small players may have to take on large amounts of debt and still are not able to efficiently produce goods for their customers to the extent that TSM can
- Low Cost Provider Moats: This is when a company can consistently be the cheapest option in the industry. Only companies that have rock bottom operating costs are able to have this moat. Retail stores like Walmart and Costco sell items for such low prices that they make it very hard for small businesses to compete with
- Toll Moats: This is when a business is a sole supplier of something the customer needs. Companies with this economic moat are usually commodity companies like oil, agriculture and utility companies that are heavily protected by the government. They usually have a monopoly over the industry.
- Cultural Moats: This is usually based on the company's value proposition, culture and branding. Starbucks is the perfect example of a company that created a cultural change by offering quality coffee in a sophisticated manner. They paved the way for artisan coffee. Coupled with economic of scale moat, they are very difficult to beat
It's very important that investors really understand how strong their company's economic moat is. If you deem its economic moat to be shrinking without any possibility of recovery, it may be best to sell your shares immediately.