Economics students will learn very early that when a business is generating high profits, it isn’t long before other companies recognise an opportunity and quickly enter the same market. In doing so they dilute the sector and bring the potential for profit down for the companies operating in it. However, even if this is true in many cases, it is not a universal rule. Some companies have been doing the same thing for many years and are still highly profitable market leaders, with limited competition. These companies have managed to create ‘economic moats’, a term first made popular by Warren Buffet, one of the world’s most successful and well-known investors. The moat surrounding a metaphorical castle that represents a business, its market share, and profits.
In other words, the characteristics of a company’s product or service, and/or the way they deliver them, are so powerful and unique that they have made it very difficult for competitors to be able elbow their way in. These are the type of companies that can often generate strong performance over a long period of time in the stock market, and those that tend to remain robust during times of stress. The below model details what will govern the strength of a company’s economic moat:
Porter’s five forces
This is a model that identifies and analyses five competitive forces acting on a company and is named after the Harvard Business School professor, Michael Porter. The five forces are:
- Competition in the industry
- Potential of new entrants into the industry
- Power of suppliers
- Power of customers
- Threat of substitute products
How to recognise them
Good companies with economic moats present attractive propositions for investors, but it can be difficult filtering through the noise to find them. There are many ways to identify firms that benefit from an economic moat, but put simply they all ask a similar question: what will prevent another company stealing market share? The below is not an exhaustive list, but gives a flavour of some of the things an investor might consider:
- Cost advantage – Can a company produce and/or sell their product or service at a discount to competitors?
- Switching costs – Does the cost of changing product/service provider make switching to a competitor unattractive for the consumer?
- Intangible assets – Intangibles are often harder to replicate and cheaper to produce, store and transport than tangibles.
- Differentiation of products/services – Does the company produce a different enough product/service to increase demand vs competitors. This could be quality, reliability, exclusivity, the list goes on.
- Is the company focused on one or several areas of expertise? – Being diverse can provide multiple revenue streams that ease volatility at times of stress, whilst having a tight focus can mean a company hones its experience and may not have to stretch resource.
- How long will an advantage last? – If a patent is close to expiration, for example, this could limit the effectiveness of the moat.
There’s no need to go very far to identify a company with a strong economic moat: Apple.
Apple created a product (the iPod) which didn’t exist before, meaning at the time there were no competitors within its space. However, the company quickly realised how easily their product could be copied, which would dilute mark share and profit, and so they decided to make their marketing and design a priority, acting as a differentiator. They have continued to move forward with both these factors at the heart of the business. Though iPods have now been discontinued, Apple’s range of iPhones, iPads, MacBooks and watches have benefitted from the same focus on design and marketing. This has built a huge, loyal user base, which gives Apple strong pricing power for their products.
In portfolios we have allocated to fund managers that consider factors driving economic moats within their own approach. The Evenlode Income fund, which we own within our Core UK allocation, looks to own companies that operate in areas with strong barriers to entry, high intangible assets and the opportunity for real dividend growth. Whilst at times these high-quality companies can come under pressure, as we saw at the beginning of this year, a long-term outlook often sees quality prevail, and the fund has outperformed its benchmark this year by 1.9%.
Source: Refinitiv – Market returns 15/10/2022 to 20/10/2022