Moats of Competitive Advantage
Investors look for “moats” or competitive advantages that create more certainty and more growth in revenue and margins. In managing or investing in businesses, it is helpful to understand what moats other companies have been able to build and why. This may help you identify a moat that you can build in your business, or take one that already exists and make it stronger. In this earlier post, I began exploring how you can begin thinking about the moats in your business.
Morningstar, the mutual fund rating company, created a Wide Moat Focus Index in 2007 made up of 20 least-expensive wide-moat stocks from a list of over 1,000. They revise the list every quarter. In order to create their list, they attempted to define what creates a moat of competitive advantage by building upon the ideas of Michael Porter, the Harvard Business School professor, in his book Competitive Advantage.
Here are the five moats that Morningstar identifies in their attempt to define moats of competitive advantage:
- Network Effect.The network effect occurs when the value of a particular good or service increases for both new and existing users as more people use that good or service.
- Low Cost Producer. Firms that can figure out ways to provide a good or service at a relatively low cost have an advantage because they can undercut their rivals on price.
- High Switching Costs. Porter defines switching costs as a barrier to entry that involves the one-time inconvenience or expense a buyer incurs to change over from one product or service to another.
- Proprietary Intangible Assets. Assets such as brands, patents, and licenses that prevent another company from duplicating a product or service.
- Virtual Monopoly or Market Control. Sometimes a business is a virtual monopoly like a public utility or an airport service provider.
Building moats of competitive advantage is a never-ending process and one where every business can always improve. It is a key to building a business and to investing in businesses, or as Warren Buffett wrote, “The key to investing is … determining the competitive advantage of any given company and, above all, the durability of that advantage.”