An economic moat is one of the most powerful things an investor can look for when they are choosing where to invest their capital. As the name suggests, an economic moat is a source of competitive advantage that makes it difficult for a competitor to replicate the profitability of the moat holder.
There are many different sources of economic moats, including patents, manufacturing processes, key personnel, or network effects. While it isn't a hard and fast rule, companies with strong economic moats generally operate in one industry or area. This helps them to reinvest profits to maintain or widen their moats relative to their competitors in that target area.
So which businesses on the ASX benefit from having an economic moat?
One of the most obvious sources of an economic moat is a legally enforceable patent that is entrenched (for a period of time) by law.
CSL Limited (ASX: CSL) is one of the best examples of this kind of business. The international producer of blood products has numerous patents relating to its manufacturing processes and the blood product compounds it sells.
It also has a secondary advantage in its scale, with manufacturing operations worldwide, so that the crucial blood plasma, protein and clotting agents that it synthesises can be close to large target markets in Europe, the United States and Asia.
The business has recently expanded beyond its core blood products business into flu vaccines. It remains yet to be seen whether they can replicate the advantage they have forged in blood products in the flu vaccine business, which could represent a risk going forward. In addition, there is increased competitive pressure in the blood products market today, which was largely muted in recent years.
Flight Centre Travel Group Ltd (ASX: FLT) is another large-cap company with a completely different kind of competitive advantage. The economic moat of Flight Centre is the huge network of company owned stores that it operates across Australia, and increasingly, in international locations such as the United Kingdom and the United States.
Each of these stores functions as its own business unit, which encourages managers and staff to be entrepreneurial and devote a lot of time and resources to superior customer service. Remuneration and bonuses at store level are also heavily incentivised to personal and store targets, which aligns the goals of the employees with the business as a whole.
A ever present and obvious risk to this moat is the increasing acceptance of online travel agents by many travellers. However, for higher value trips, and for complex multi-stage journeys, Flight Centre appears to retain an advantage in service and thoroughness that is given by its staff.
In addition, Flight Centre retains the option to "flick the switch" to a hybrid online / in person travel agent model, where it can leverage its experience, brand familiarity and trust in an online environment.
REA Group Limited (ASX: REA) is the holder of a third kind of economic moat: the network effect. Put simply, this effect means that customers will go to the place where the most options are, and sellers will want to sell their products in the place that has the most customers. While this network effect is hard to achieve, once it is attained, it is hard to replicate for competitors. Facebook has this kind of network effect in social media, as does Gumtree for second-hand goods sales in Australia.
REA Group benefits from a network effect in the real estate and home sales market in Australia. Home buyers gravitate towards realestate.com.au because it has the most homes for sale, while those selling prefer to list their properties there as it draws the largest audience of possible buyers.
REA Group comes under competitive pressure from Domain.com.au in Australia, however, recently published metrics show that visitors spend far more time on REA Group's site than its competitor. Another risk is that the attempts of REA Group to replicate this economic moat in south-east Asia, Europe and the United States through stakes in (or ownership of) various online property portals have the potential to distract management and drain capital from the lucrative Australian business.
Foolish takeaway
On its own, an economic moat does not signify a great investment, as future competition can erode or wipe out a moat. However, companies with moats tend to outperform over the long term. REA Group appears to have the most room to grow, Flight Centre's moat is subject to the most competitive pressure, while CSL has the most durable moat in the form of patents and manufacturing scale.
