When it comes to investing, most analysis is based on quantitive data. Investors look at things like the balance sheet strength, profitability figures and valuation ratios. Whilst the numbers of a business are key to figuring out its financial health and how it has historically performed; you need to look at its strategy to see where it is going in the future. You need to assess how the company makes its money to see if its profitability figures are viable going forward. You need to evaluate the quality of a business to see if it is worth investing in over the long term.
In economics, mean reversion is the theory suggesting that prices and returns eventually move back toward the mean or average. So if a particular company has had above average returns over the years, sooner or later, that company will become average and produce average returns due to factors such as increased competition and technological change.
When looking at mean reversion in an investing context, it should follow that no company should earn above average returns over long periods of time. But the reality is different. Companies like Coca-Cola, Colgate Palmolive, Amazon and Starbucks have vastly outperformed their peers over long stretches and the probability of them continuing to do so is very high.
The reason certain companies are able to outperform over long periods of time is due to competitive advantage; or Economic Moats as Warrren Buffet Likes to call them.
What is competitive advantage / economic moats?
A competitive advantage is an advantage over competitors gained by offering consumers greater value, either by means of lower prices or by providing greater benefits and service that justifies higher prices
Look at the following example to see why investors should care about economic moats.
At Blue Nile (NILE), you could buy a 1.08-carat, ideal-cut diamond with G color and VSI clarity mounted in a platinum band for about $8,948.
At Tiffany (TIF), the same ring would cost you $13,900.
That’s $4,952 more… just to have it in a Tiffany blue box.
It shows you the power of a brand. It’s Tiffany’s moat. Competitors can sell the same diamond, but they can’t put it in a Tiffany blue box. This fact helps drive stock returns, too.
Blue Nile’s stock is down about 24% since it went public in 2004. That’s more than a decade of no return for investors.
By contrast, Tiffany’s total return (including dividends) is up 45-fold since it began trading in 1987. That’s even after its recent beating.
Tiffany has a moat. Blue Nile does not. (The above example comes from Pat Dorsey’s The Little Book That Builds Wealth.)
An economic moat is what protects your business from its competitors. It allows you to do things your competitors can’t do – like charge $5,000 for a blue box. It’s also the engine behind some mega stock winners.
Different Types of Economic Moats and Competitive Advantages
Now that you know how important competitive advantages (economic moats) are in the world of business and investing, here are some of the things to look for in a business to ensure that it outperforms.
1. Low Cost Producer – One reason companies can continue to outperform over long periods of time is due to cost leadership. It is cheaper then everybody else. Due to their sheer size, companies like Amazon, Walmart and Toyota can charge lower prices than their competitors for similar products due to their economies of scale; increased savings due to high volume production. And as the company gets bigger, there is more savings to be made due to things such as buying your inputs in bulk for cheaper prices. So as you can see, this is a recurring loop – the big companies get bigger and more possible by selling more and more stuff for cheaper prices.
2. A strong brand – Tiffany has a moat, as seen above. People pay up just to get that blue box, even though what’s in the box might cost less somewhere else.
Starbucks is another example of a company with a great brand. It inspires loyalty and ensures recurring customers.
When Starbucks was founded in the 1970s, a cup of coffee was about $0.50. Starbucks got people to pay a couple of dollars for their coffee by playing up the coffee’s quality. It also brought McDonald’s-like quality control to coffee to ensure a cup of Starbucks coffee tasted the same everywhere. This was a big innovation at the time. And it has made the Starbucks brand the powerhouse it is today.
I remember reading about how some of the venture capitalists who looked at Starbucks early turned it down. They couldn’t imagine people paying so much for a cup of coffee…
But as you know, the stock has been a monster winner, up more than 18,000% since its initial public offering in 1992. And it’s up close to twentyfold since 2008…
3. Switching Costs – A company has a moat if it costs the customer to switch. Apple is a customer that is brilliant at this. People with Apple products will never leave the company due to how much they have invested in the Apple ecosystem. By switching to Samsung Galaxy or a different android phone for instance, the customer will lose out by having to purchase music and apps all over again. People like simplicity and not losing money so with with Apple products today will continue buying Apple products and further tie themselves to the company.
Banks can have this kind of moat, too. There isn’t much of a competitive advantage that one bank can have over any other. They all have the same products. And with the Internet, branch locations aren’t important.
Yet when you look at the numbers, people tend to stay at their banks for six to seven years. That’s because it’s a pain in the neck to change banks. As economists say, “switching costs” are high. That’s a moat.
4. Network Effects – Microsoft (MSFT) had a great networking moat for years. Everybody else used its operating system, so you wanted to, too. The more people used Microsoft’s operating system, the more it enjoyed network effects.
There are lots of network moats today. Think of Facebook (FB), Twitter (TWTR), or YouTube. It’s very hard for competitors to replicate these businesses, to crack the network moat. It’s like trying to sell the first telephone.
5. Distribution Networks – Coca Cola has the greatest distribution network in the world. And it don’t happen by accident, they worked really hard at it. They gave retail businesses free refrigerators with the clause that they can only stock coca cola products in them. And if yours is the only product on the shelves, you have the whole market to yourself. Even a giant company like Pepsico had to buy out whole restaurant chains like Pizza Hut, KFC and Taco Bell just so that they could push their product via these networks.
Another example of a company with distribution advantages is Nestle. They have their products entrenches in certain societies, like Milk in India
6. Size – Absolute bigness can be an advantage if it keeps competitors out. Imagine what it would take to try to replicate the research capabilities of Intel (INTC) or the purchasing power of Wal-Mart.
Relative size can also be a moat. If you’re the dominant insurer of small taxi fleets, as Atlas Financial (AFH) is, then you have a moat. Competitors are unlikely to invest the time and energy necessary to compete in a niche market.
7. Intellectual Property and Patents – These types of economic moats are becoming more and more important as technology progresses. Take Qualcomm for instance. They patented communication technologies that are used in mobile phones today. So with every mobile phone sale, no matter the brand, Qualcomm makes money.
8. Regulation – Certain companies have advantages due to the highly regulated nature of the industries they operate in . National Grid is one as it controls all the electricity transmission networks in the UK. BT is another company that controls all phone lines and most broadband connections via its open reach subsidiary. Regulated industries can bring about monopolies which is a great moat for investors as it means high profit margins.
The tobacco industry is another example of how regulation has driven down competition, driven up barriers to entry and created monopoly profits.
9. High Cost Infrastructure – American Tower (AMT) owns cellphone towers and leases them out to carriers. Its gross profit margin last year was an astounding 73%. It’s a great business. Once it has a tower in place, it’s tough for a competitor to justify putting up another one in the vicinity. And every “tenant” AMT adds to an existing tower is almost pure profit.
10. Unique resources – If the company you are invested in has the rights to a particular product or has the only mine for a particular resource, you can monopolise that industry.
The next time you want to invest in a company, see if it ticks any of the above boxes. The truly special companies such as Colgate Palmolive, Nike and Visa have more than one moat. If you ever find these companies trading at reasonable valuation, your only thought should be to buy. Your future self won’t regret it.