What is a moat in investing?
An economic moat is an investment strategy that involves seeking out companies with a sustainable competitive advantage, or a 'moat'.
Like a castle surrounded by a moat for protection against attack, a moat in business refers to a company's unique advantage that makes it difficult for competitors to challenge its position in the market.
The theory is the moat protects the company's market position, allowing it to generate long-term profits. Determining the competitive advantage of any company is crucial to investing, and a more extensive moat makes a stock a better bet.
What are the five main types of moats?
Five main types of economic moats provide companies with long-term competitive advantages.
- Low-cost production: Companies that can produce goods or services at a lower cost than their competitors (through economies of scale, for example) can attract more customers by offering lower prices, which their competitors can't match.
- High switching costs: Switching costs lock customers into an ecosystem and make moving expensive. Data moats are one example of this — for instance, if you decided to leave gmail for another messaging platform, you would lose your list of contacts and historical messages. Sure, you can export them, but that comes at a time and convenience cost.
- Network effects: Some products become more valuable as they acquire more users – think Uber Technologies Inc, eBay Inc, or Etsy Inc. A business model that requires a strong network effect is an extended play. A slow, costly grind eventually hits a tipping point when exponential growth finally delivers profitability. The network effect is a powerful moat. It's one that many start-ups deploy. The primary goal is user acquisition. Profitability can be sorted out later.
- Intangible assets: Intellectual property such as brands and trademarks can provide a competitive advantage. Companies with well-established brands that consumers trust can also have an advantage over competitors. For example, consider how many consumers are willing to pay extra for brand-name goods.
- Efficient scale: When a company processes a high volume of transactions, they can enjoy lower costs for each transaction and then pass the savings to customers through lower prices. This helps massive retailers sell goods for prices that would bankrupt smaller companies.
What does Warren Buffett say about company moats?
Legendary investor Warren Buffett is known for his emphasis on investing in companies with strong economic moats, reflecting their ability to maintain a competitive advantage and sustain long-term profitability.
The Oracle of Omaha often shares his words of wisdom on the subject, saying:
In business, I look for economic castles protected by unbreachable moats.
The most important thing is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.
Buffett advises that the key to investing is not assessing how much an industry will affect society or how much it will grow but rather determining the competitive advantage of a given company and, above all, the durability of that advantage.
He believes that companies with economic moats can fend off competitors and maintain long-term profitability, thus making them a wise investment choice.
How do you identify a company's moat?
Identifying a company's economic moat involves looking at the factors contributing to its competitive advantage.
Here are some common ways to identify a business's moat:
- Brand recognition: A company with a well-known brand has an advantage over its competitors because consumers are more likely to choose a familiar product over an unknown one.
- Intellectual property: A company with patents, trademarks, and other forms of intellectual property has a legal monopoly on its products or services, giving it an advantage over competitors.
- Cost advantages: A company with lower costs than its competitors can charge lower prices, which can help it gain market share.
- Network effects: A company with network effects has an advantage because its products or services become more valuable as more people use them. Social media platforms like Facebook and LinkedIn give their owners strong network effects.
- High switching costs: This makes it difficult for customers to switch to a competitor's product or service. For example, software companies like Adobe Inc and Microsoft Corp have high switching costs. Customers invest time and money into learning their software and may find switching to a new product difficult or inconvenient.
- Regulatory protection: Companies that operate in regulated industries may have an advantage because it is difficult for new competitors to enter the market.
Identifying a company's economic moat involves analysing its competitive advantages and considering the difficulty in replicating them. It's important to look at various factors to get a complete picture of a company's moat.
Examples of ASX companies that benefit from a moat
Many ASX shares benefit from having a moat. Examples include:
ASX healthcare share CSL Limited (ASX: CSL) has a strong economic moat thanks to its intellectual property portfolio, which includes more than 1,500 patents and trademarks. CSL's expertise in plasma fractionation, the industry's high barriers to entry for new competitors, and the company's extensive global distribution network also contribute to its moat.
Cochlear Limited (ASX: COH) is a medical device company specialising in hearing implants. The company also has a robust economic moat due to intellectual property, with 500 patents and trademarks. Cochlear's reputation for producing high-quality and reliable products and its extensive global distribution network also contribute to its moat.
Transport share Transurban Group (ASX: TCL) is a toll road developer and operator that manages, maintains, and operates toll roads in Australia and North America in partnership with governments and other private sector companies. Thanks to its economies of scale and high entry barriers, it has a competitive advantage in the toll road industry that is difficult for other companies to replicate.
Tech share Xero Limited (ASX: XRO) is a cloud-based accounting software company that provides a platform for small businesses and accountants to manage their financial records and operations. Xero has a first-mover advantage as one of the first cloud-based accounting software companies. Its software allows it to integrate with other software applications used by small businesses, such as point-of-sale systems, e-commerce platforms, and payment gateways.
Investment options: Stocks and ETFs with moats
As mentioned, moat investing means investing in companies with sustainable competitive advantages trading at attractive valuations.
These sustainable competitive advantages are expected to enable the companies to fend off competition and maintain or grow profitability.
Moat investors seek to identify companies with the benefit of economic moats and invest in the companies when their shares are undervalued.
For investors who prefer not to pick individual stocks, VanEck Morningstar Wide Moat ETF (ASX: MOAT) tracks the price and yield performance of 49 of the most attractively-priced companies with sustainable competitive advantages, as selected by Morningstar's equity research team.
Most of these companies are located in the United States. Since its inception in 2015, the ETF has returned 15.24%, including distributions. The S&P 500 has returned 12.36% over the same time frame.