In the 1995 annual meeting of Berkshire Hathaway (NYSE: BRK.B), Warren Buffett introduced the concept of a “moat” as the fundamental rule of economics in the firm’s investment strategy.
Warren Buffett explained, “The most important thing is trying to find a business with a wide and long-lasting moat around it, protecting a terrific economic castle…”.
With Berkshire’s portfolio worth US$331.7 billion, some of Warren Buffett’s selections like Apple (NASDAQ: AAPL) and Coca-Cola (NYSE: KO) have paid off handsomely.
As smart investors, we can draw valuable insights from Warren Buffett’s approach and apply these strategies to our future investment choices.
What is a “moat”?
The dictionary defines a moat as a deep, water-filled trench surrounding a castle, designed to protect it from enemies.
In business terms, a moat refers to a company’s ability to maintain its competitive advantages over its competitors, thereby protecting its market share and profitability.
Consider some of the world’s largest companies.
They share a common characteristic: a key element that keeps customers returning.
One such example is the Apple ecosystem.
Apple has built a comprehensive network of products, services and solutions to encourage its existing user base to stay committed to the brand.
This ecosystem effectively acts as a moat, securing Apple’s competitive edge and maintaining its market dominance.
Morningstar (NASDAQ: MORN), an investment research firm has identified five types of moats that contribute to a company’s long-term success.
Different types of moats
These five moats are: 1. Switching costs, 2. Network effect, 3. Intangible assets, 4. Cost advantages and 5. Efficient scale.
We will dive deeper into these moats and understand why they make a business successful.
1. Switching costs
Let us return to the Apple ecosystem example.
Apple’s suite of products is designed to complement one another, featuring cross-platform capabilities to enhance user experience across an assortment of devices.
This integration means that the more Apple products an individual purchases, the greater the benefits they receive.
As a result, once an individual buys just one Apple product, they are more likely to continue purchasing, thus demonstrating the stickiness of Apple’s ecosystem.
This “sticky” feature makes it costly for users to consider switching to other platforms, such as Android or Windows, while also creating inconvenience.
As a result, Apple’s products command a premium while continuing to enjoy healthy demand.
Another example of high switching costs can be seen in the software industry.
The recent global information technology (IT) outage perfectly illustrates the dominance of Crowdstrike (NASDAQ: CRWD) in the cybersecurity sector.
Crowdstrike is a global cybersecurity leader, protecting over half of the world’s Fortune 1,000 companies.
With 8.5 million Windows devices affected worldwide, businesses that implement Crowdstrike’s security services on a large scale might find it tough to switch despite the disruption.
This difficulty arises because clients’ systems are deeply integrated with Crowdstrike’s cybersecurity platform, resulting in prohibitive switching costs.
2. Network effect
The network effect occurs when the value of a product or business increases as more people use it, making the business more valuable.
An example will be Meta Platforms (NASDAQ: META) and the company’s portfolio of social media platforms such as Facebook and Instagram.
The main revenue generator for Meta Platforms is advertising, accounting for 97.8% of its total revenue in the first quarter of 2024 (1Q 2024).
As more users engage with its platforms, the network effect enhances the platform’s attractiveness to advertisers, thereby increasing Meta Platform’s revenue.
With more advertisers on board, more users will then be attracted to use Meta’s suite of social media platforms, thereby helping to increase user uptake in a virtuous cycle.
Another illustration of the network effect is payments giant Visa (NYSE: V).
With 4.4 billion cards distributed globally across 200 countries, Visa has secured a commanding foothold in the online digital payments industry.
This extensive reach means that almost all merchants must accept Visa as a form of payment, kicking off a virtuous cycle that increases Visa’s customer base.
With more merchants accepting Visa as a form of payment, Visa’s ecosystem becomes more valuable to potential customers.
This creates a multiplier effect to attract both merchants and customers to join Visa’s platform, compounding Visa’s reach and influence in the global payment solutions market.
3. Intangible assets
Intangible assets include a variety of assets such as patents, brand names, intellectual property, or other forms of intangibles that prevent competitors from replicating a company’s products.
This is commonly seen in research-heavy industries such as technology and pharmaceuticals.
Eli Lilly (NYSE: LLY) is a pharmaceutical company that produces a range of drugs for a variety of illnesses.
Eli Lilly relies heavily on patents to protect some of its most commonly prescribed medications.
The patents filed by Eli Lilly are critical for the company’s competitiveness, granting the company significant pricing power and protecting its profitability.
Similarly, brand reputation is another form of intangible asset that is hard to replicate.
This is exemplified by luxury brands such as LVMH Moët Hennessy Louis Vuitton (EPA: MC) and Hermes (EPA: RMS), which charge a premium for their products.
4. Cost advantages
Cost advantages occur when a firm is able to outcompete competitors with superior margins.
This can stem from multiple reasons, such as first-mover advantages, better efficiency, or economies of scale.
As the world’s first dedicated foundry, Taiwan Semiconductor Manufacturing Company (TSMC) (NYSE: TSM) enjoys a significant first-mover advantage.
The chip-making giant now holds a near-monopoly for producing some of the world’s most advanced chips, given the cost associated with chip manufacturing equipment and plants.
Another example is Netflix (NASDAQ: NFLX).
With 277.7 million paying subscribers as of 30 June 2024, Netflix can achieve significant economies of scale.
The company can spread its large fixed costs, such as content creation or licensing, across a vast number of users.
5. Efficient scale
Companies that operate in industries with few competitors can benefit from efficient scale, thereby attaining a monopoly-like status.
Efficient scale often arises from various factors, such as geographical limitations or intensive capital costs associated with entry.
This concept is commonly seen in industries such as transportation, telecommunication, and utilities, where infrastructure investment is substantial.
Companies like Singtel (SGX: Z74) and StarHub (SGX: CC3) are major telecommunications, internet, and cable providers in Singapore.
The high costs of setting up base stations and other network infrastructure act as a barrier for new entrants.
In addition, potential entrants must be prepared to sustain steep losses for customer acquisition as the pool of customers is limited by Singapore’s small population,
Having an array of moats
While these moats are certainly useful in identifying which companies are suitable for your investment, companies that display multiple moat categories offer the best bang for your buck.
These companies are well-positioned for enduring success.
Microsoft (NASDAQ: MSFT) is a prime example of a company with an array of moats, which has helped propel the company to become the second-largest globally.
Several segments have high switching costs, such as its gaming business with the Xbox platform, or Azure Cloud, Microsoft’s cloud computing service.
Additionally, the network effect is also exhibited with Microsoft’s ownership of LinkedIn or GitHub, which benefit enormously from a growing user base and community.
Microsoft also holds approximately 70,000 patents, which protect its technology and products from being easily replicated by competitors.
Get Smart: Concluding thoughts
Understanding economic moats is crucial for any investor to make informed decisions when investing.
Investors should not chase after companies with unsustainable profit and revenue growth but instead consider the company’s long-term prospects.
Quoting Warren Buffett, “We are trying to figure out what is keeping — why is that castle still standing? And what’s going to keep it standing or cause it not to be standing five, 10, 20 years from now”.
The Sage of Omaha has detailed just what we should be looking for when sifting out great investment ideas – whether the business has an enduring competitive moat that can stand the test of time.
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Disclosure: Aw Kai Rui does not own any of the stocks mentioned in this article.
