Why Your Business Needs a Moat to Succeed?
In business, I look for economic castles protected by unbreachable ‘moats’.- Warren Buffet
An essential component of Warren Buffets' investment strategy is what he calls a ‘moat’. In business, a moat refers to the competitive advantage of a company to sustain and protect its long-term profits and market share from competing firms. Like its namesake — a water-filled ditch — Buffett’s moat refers to a defensive barrier, but instead of protecting a castle, it helps prevent a company’s profits from being eroded by competitors.
Buffet’s advice to business managers is to make their moats bigger and wider. A moat is a defensive measure that allows a firm to retain a leadership position and increase margins.
Building a competitive advantage that ensures never-ending profits till doomsday sounds extremely optimistic and unachievable.
A real-life everyday example would be Uber. Uber has become an archetypal example of a company built on aggregating supply and demand. The company has a massive moat — its network of drivers and riders in thousands of cities around the world. No competitor is even close. It takes tremendous capital expenditure to build that network, and it will take tremendous capital expenditure to neutralize it.
Uber’s ability to aggressively add drivers and riders to its platform through marketing and promotions kickstarted those network effects in each new market it entered, and the virtuous circles that resulted drove the company’s fast growth around the world. Uber’s power oversupply and demand — the guaranteed, fast, cheaper-than-a-cab rides that it can offer both customers and drivers — has been its key competitive advantage against competing rideshare companies. As smaller competitors have emerged to challenge Uber in local markets, Uber’s ability to manipulate its own supply and demand economics has helped it stay competitive. The ride-sharing company simply lowers rider fares and increases drivers’ incentives. However, this strategy has been less effective against Lyft, which has become increasingly able to offer similar incentives within its marketplace, competing with Uber on price and driver availability. Since there’s little friction for drivers or users to switch between apps, there’s little keeping someone from choosing one app over another.
Ultimately, to win against Lyft, Uber is betting not only on its marketplace moat, but also reinvesting in its brand, hoping that its familiarity can give it an edge in a newly commodified rideshare industry. It is also investing in various other services and verticals including, such as e-bikes and food delivery.
Uber’s Delivery segment offers an app that lets people order meals from restaurants remotely for either pickup or delivery. For delivery, customers are matched with drivers similarly to how they are for Uber’s ride-hailing business. The segment was first launched in 2014 as UberFRESH, before becoming UberEATS in 2015.
But how can you apply this in your business now that you know its importance?
In the 20th century, the biggest companies in the world were built on moats of economies of scale or government. Today, however, the most durable moats are being built on different types of advantages, such as network effects, data, and repeat engagement within a product ecosystem.
Give a guess which moat is Uber built on.
You have plenty of options while setting up a moat for your business. Imagine the moat being a barrier to entry in your industry, the bigger the barrier the more you profit. Your moat could be IP, loyal customers, reputed brand, and/ or execution capability.
According to Morningstar, the financial services company based in Chicago, Illinois, US, the factors which give economic moat to a business are the following:
- Cost Advantage: What is a cost advantage? Example: two companies A & B sell a similar product at the same price. But A’s margin is better than B’s. In this case, A can said to have a cost advantage over B. In other words, we can say that A has a wider moat than B.
- Switching Cost: It is a cost on customers. Suppose there is a company that is using SAP as its ERP system. Now the company decides to switch from SAP to a Cloud-based ERP (like Workday). To do this, the company will have to make a large investment (switching cost). When switching cost is high, customers might prefer to stay with the existing product. This choice of the customer gives a moat to companies like SAP.
- Intangible Assets: Suppose you like a company whose main line of operation is machining. If you want, you can duplicate and establish a similar workshop of your own. But suppose, instead of a machine shop — it is a company which has a huge “Brand Name”. It will be exceedingly difficult to create a parallel of such a company. Strong brand recognition gives moat to companies.
- Market Limitation: Suppose there is an island country whose population is 1 million only. There are already 3 automobile companies which operate profitably in the place. A new company wants to enter the market. What will happen? First, as it is an Auto company — the cost of capital will be huge. Second, as the market is limited, a new entry will only reduce the profitability of every competitor. Company’s do not prefer to set up operations in such a market. Hence, such a market allows moat build-up for existing companies.
- Network Effect: Recently we have seen Auto companies like KIA and MG, etc entering the Indian market. Do you know what is their biggest entry hurdle? Not a product — but building a network. Companies like Maruti, Tata, Honda, Toyota, VW, Skoda, etc already have a dealer-service network. Considering India is a big country, establishing a wide network is a huge cost for the company. They may opt for the franchisee model, but that too will take time as their brands are not as established. This network effect gives moat to existing auto companies like Maruti, Tata, etc.
Based on these parameters of Morningstar they also publish a list of stock that has a wide moat. Top moat stocks as per Morningstar are these.
For value investors, there is nothing better than a wide moat stock trading at undervalued price levels.
“Wide moat” is not a financial metric or ratio which can be easily measured. A researcher must conclude it based on self-study.
So instead of asking when a start-up will or can become profitable, the real question to ask is if start-ups are investing in building moats that will create profitability as they mature and grow. Unfortunately, most businesses don’t have moats and will never have one. If you don’t have a moat, then you can only compete on prices that will hamper profits and in the end, your business becomes stagnant.
As the start-up ecosystems around the world keep on maturing, it is imperative that we include a conversation about profits as a part of our cultures. It will be difficult to salvage older businesses that rely on new capital to survive, without having invested early enough on a moat. But there is an opportunity to help build new businesses that have a better opportunity to create long-term value, based on the strength of their business model and especially the durability of their moat.
Cheers
