Do you have moat in your portfolio: Understanding Economic Moat

Introduction

When it comes to making a sound equity portfolio, an economic moat is key. But what does it mean? And what do you need to look for when leveraging a stock's competitive advantages to your portfolio? Let's find out.

What does economic moat mean?

An economic moat is a competitive edge that allows a company to reap good profits over an extended time. 

When investing in stocks, you may want to look for companies that have a strong and growing competitive advantage and trading at a reasonable price multiple.

To help you identify a company’s competitive advantage, you will need to understand the competitive barrier or defense the company has built for itself in the industry.

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The importance of economic moat in your portfolio

From an investment point of view, a moat is important. This is because any time a business develops a valuable product or service, it won't be long before its competitors attempt at producing a comparable, if not a better, output to take advantage of that opportunity.

Therefore, any competitive advantage held by a company is always at risk of being copied.

But what you may want to know is how the power and sustainability of a company's economic moat determines if it can prevent competitors from eating into its profits. Companies with wide economic moats are regarded as favorably positioned to keep rivals away for a long time.

Types of economic moats

Let's look at four main types of economic moats. They are:

1. Low-cost producers

A company that produces goods or services at a low cost, generally due to economies of scale, may display a distinct competitive advantage as they can cut their competition on price. 

Example

Simply Super Mart is a low-cost retailer that prices its products attractively. As a large player in the retail industry, it’s size gives it enormous scale efficiencies or operating leverage that allows it to keep costs at a minimum. Besides, it enables demand to make efficient purchases given its several locations across the country. Now, since Simply Super Mart positions itself as an economically low-cost retailer, it ensures low prices to its customers. This means strict bargaining terms for retail brands looking to sell their products on its shelves. Hence, Simply Super Mart’s product prices are difficult for its competitors to match.

2. High switching expenses

Switching costs are those expenses that a customer may have to incur to move from one product to another. Switching costs can be monetary, psychological, time-based or effort based that the consumer has to pay if they switch to another brand or product.

Example

Let's say you've had to change your bank account. It was a slow, extended and time consuming process to update your account information at various places. This also involved a good deal of your time and effort.

As the building block of competitive advantage, switching costs determines the pricing power of a company.

3. Network effect

Regarded as a decisive competitive advantage, the network effect is also an easy one to support. This effect occurs when the value of a product or service increases as more and more people start using those goods or services. 

Example

As more and more people get on to social media platforms such as Twitter or Facebook, the more valuable these platforms have become to the public. Because of their large user base, these companies have a distinct advantage and they can charge premium pricing.

4. Intangible assets

A business may have a competitive advantage over its rivals because of its nonphysical or intangible asset. These assets may be in the form of intellectual property rights, brand names, patents, geographic advantage and even government licenses. While it may not be easy to assess, intangible assets can be a significant source of competitive advantage for any business and an essential source of economic moat. 

For instance, a company can use its patent to safeguard its inventions from other competitors. Similarly, a company can use a government license issued for mining minerals to keep the new competitors at bay.

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Conclusion

Identifying an economic moat may require a lot more effort than simply looking up a company's history. But take the time and effort to understand a company's competitive position. You will be able to get an in-depth view of its long-term profitability and make the right investment decisions. Like the legendary investor Warren Buffet stated, "In business, I look for economic castles protected by unbreachable moats”.

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