From a stock market investor's perspective, one warfare-related term that is significant is "moat". Legendary investor Warren Buffet uses it widely and is perhaps responsible for both the word and the concept behind it gaining wide currency within the investment world. He once said: "The most important thing to me 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."
What is a moat?
A moat is a deep and wide ditch filled with water which surrounds a castle, building or town. In medieval times, the moat served as the preliminary line of defence against the enemy.
Often, before investing in a business, investors look at the company's historic performance. If over the last five years, earnings per share (EPS) has grown at a robust pace, investors invest in that company's stock, believing that the company will manage to grow its EPS at a similar (or perhaps slightly lower) rate over the next five years as well. This often proves to be a mistake. The reason: it's the very nature of capitalism that if a company makes excess profits in a certain line of business, its success attracts competitors. As competition increases, the supernormal rate of profit gets eroded. But there are companies that have been highly profitable for long periods. What accounts for their prolonged success? The answer is that a company can continue to earn supernormal profits for a long period if it possesses an economic moat, or a source of sustainable competitive advantage. Thus, economic moat is a metaphorical way of referring to the competitive advantage that a company has over its industry rivals.
Just as a moat protected a medieval castle, similarly an economic moat is a barrier that protects a firm's profits against competitive pressures. Ideally a firm would like to have an economic moat that is both deep and wide. When a firm enjoys a deep economic moat, its margins and hence its profits are high every year. And when a firm's economic moat is wide, its profitability remains intact for a long period. When, for instance, a competitive advantage is based on technology, the economic moat is usually deep (profits are very high each year) but not wide (a rival soon comes up with a product based on a superior technology and takes market share away).
Thus, when investing in a stock, look for companies that possess deep and wide economic moats. In fact, this should be the most important qualitative criterion on the basis of which you should select stocks.
Types of economic moats
A company can employ one or a combination of the following ways to sustain its competitive advantage:
Ø Product differentiation;
Ø Branding; low price;
Ø Locking in customers; and
Ø Locking out competitors.
Product differentiation: A company can capture a disproportionately large market share by launching a product that boasts of a superior technology that it rivals do not possess, and features that they can't replicate. Usually these innovative products are launched at a premium price, which makes them very profitable. There is no dearth of customers willing to pay more in order to get their hands on products with the latest technology and the best features.
The problem with this kind of competitive advantage is that it is usually short-lived. Technology is constantly advancing. Today's market leader can quickly become tomorrow's laggard. In fields such as information technology and electronics, competitors are churning out superior products at ever faster rates and obsolescence levels are high. It is for this reason that celebrated money managers like Warren Buffett and Peter Lynch famously refuse to invest in high-tech companies.
Branding. A more lasting way to build competitive advantage is by developing a powerful brand, which is why companies are willing to spend enormous amounts on brand-building activities. Their aim is to deliver the message to their target audience that their products or services are better than those of their competitors.
In India Thums Up is a powerful brand. When Coca Cola bought Thums Up, it underestimated the power of this brand and tried to push Coke instead. It was only when Coke failed to make quick inroads into the Indian market that it realised its mistake. For once it made an exception to its global rule and decided to have two brands within the cola segment.
The continued success of Coca Cola Company is itself a testimony to a brand's ability to provide unmatched competitive advantage to a company for centuries. After all, anyone can manufacture and sell a carbonated drink. Then why has Coca Cola remained successful for centuries?
Designer labels for apparels and accessories also demonstrate the power of branding. Customers willingly pay a premium for branded apparels than for a similar unbranded item. Take the example of Tiffany's or our very own Tanishq. People willingly pay a premium for these jewellery brands.
Remember that branding is primarily about perception. So long as people perceive that a particular brand offers superior value, they will be willing to pay a premium for it, irrespective of whether it truly does or not. The value of a brand is in fact measured in terms of the premium that customers are willing to pay for it vis-à-vis the commodity version of the same product. By boosting a company's profit margins brands can create deep and wide economic moats.
However, branding does not work in all industries. Especially in high-tech industries (electronics, computers, etc) customers are guided more by technical specifications and product features than by branding. For instance, Sony has a powerful brand and it was also the inventor of the Walkman (the first individualised music player). But today's youngster covets an Apple ipod. Tomorrow if another company comes out with a better product that offers superior value, customers will switch loyalty at the drop of a hat.
Low price. Offering the same or a similar product or service at a lower price can be a powerful economic moat. Cost advantages are created by either inventing a better process or by achieving larger scale.
Dell is an example of how a better process can reduce costs. Dell's PCs are built only after purchase orders are received. This way Dell avoids stocking up on inventory (thereby lowering its working capital requirement). This is especially beneficial within the computer industry where the value of inventory erodes very fast. At the same time, Dell is able to take advantage of any decrease in the price of PC components.
Players who achieve scale also enjoy a powerful competitive advantage. Their fixed cost per unit is lower, so they can sell at a lower price. Their lower price in turn gets them more customers, thereby creating a virtuous cycle that is hard for competitors to match.
However, the low-price advantage is also difficult to sustain over a long period of time.
Locking in customers. Companies can deter customers from switching to competitors' products by creating high switching costs. This cost need not only be in terms of money; time is often a more powerful deterrent. If the customer has to undergo significant amount of training and incur lost productivity during the training period, he will be reluctant to switch. For instance, Adobe's software such as Photoshop and Illustrator are the ones on which most designers hone their skills during their training period. For them to shift to another design software would require the investment of time and effort. Unless the gains from such a switch are substantive, they would be reluctant to switch. The more tightly integrated a company's products are with a customer's business processes, the more difficult it is for the latter to switch.
Locking out competitors. Companies can also create a powerful economic moat by locking out the competition using tools such as patents and intellectual property rights which protect their owners from direct competition for a given period of time. Innovator companies within the pharmaceutical industry use patents to earn huge profits (while the patent lasts).
Licences are another means through which competitors can be locked out. Since the number of people to whom the government gives the licence is limited, the competition in such spheres is also limited. That means outsized profits for the licence holders. In the US, for instance, a limited number of licences are given for running cabs in New York, because of which these licenses are highly prized. When hunting for good investment prospects, look for companies that have a solid track record of growth and profitability. Then ask yourself: what are the characteristics that have enabled this company to earn sustained profits over such a long period of time? If you look closely, you will find that the business possesses one or the other of the economic moats described above. Then ask yourself: will this economic moat survive in future also or will it be breached by competitors? If the answer is yes, go ahead and invest in its stock.
