Economic Moats and Competitive Advantages
Source of competitive advantages, market dynamics, benefits, and examples
As quantitative data and analytics become increasingly commonplace, the qualitative assessment of a business becomes an increasingly important part of the investment process. Thoughtful consideration can provide differentiated insight on the company’s long-term outcome.
Moats and competitive advantages allow companies to maintain a strong business over time. Truly understanding a company’s potential requires understanding their strengths and opportunities, within the context of the industry and competitors.
What is a moat?
Moat - /mōt/, noun - A deep, wide ditch surrounding a castle, fort, or town, typically filled with water and intended as a defense against attack
– Oxford Languages
The term moat was coined by Warren Buffet to describe a company’s unique set of competitive advantages.
Sources of competitive advantages
Firms seek to create sustained competitive advantages to counteract the tendency of commoditization. The two basic forms established by Michael Porter are:
Cost leadership – providing the same value as competitors, at a lower cost
Differentiation – providing unique value relative to competitors
These can be extended into more nuanced sources of competitive advantages including, but not limited to:
Ecosystem – a robust platform for all stakeholders
Talent – hiring and keeping the best people
Process – differentiated inputs, methods, or practices
Data – accumulating the best data sets, enabling the highest level of insight
Channel – differentiated approach in distribution
Culture – often expressed through values; how the company thinks and operates, their ability to adapt
Market dynamics
Companies look to leverage these sources of competitive advantages through market dynamics such as scale, barriers to entry, and switching costs.
Scale
Economies of scale allow larger companies to drive down costs. Other scale advantages may include more resources for R&D or opening other strategic opportunities such as partnerships.
Walmart, Costco, and Amazon are examples of economies of scale for cost leadership. Scaled economies shared
Companies such as Netflix, Datadog, and Veeva have been able to reinvest heavily into R&D to improve their offerings as they grow, further distancing their products and services from potential competitors.
Barriers to entry
Barriers to entry make it difficult for competitors to enter the market. Barriers may include, but are not limited to, network effects, regulatory requirements, strong branding, infrastructure needs, and other large capital expenditures
Facebook is the prototypical network effects example. They’ve been successful not only with their core platform, but with their acquisitions including Instagram and WhatsApp.
For an example of network effects beyond social media, consider Visa. Visa has created a strong network, enabling consumers and businesses to connect across the world and online.
Veeva, the healthcare cloud, and Intuitive Surgical, the leader in minimally invasive robotic surgery, benefit from complex regulatory requirements. Having overcome them themselves, they are well positioned.
Switching costs
Having won over a customer, companies want to then keep them. High switching costs make it more difficult for customers to leave.
High switching costs can be created such as the lock in contracts of mobile networks and airline loyalty programs.
Switching costs can also be structural. Enterprise software companies, often offering highly critical functionality, tend to benefit. When a business adopts Salesforce, for example, the platform becomes core to their operation. To migrate out of Salesforce would be an operational nightmare.
Benefits
The sources of competitive advantages and market dynamics lead to beneficial outcomes for companies that leverage them. The desired result is to sustain their business and positioning in the market over time, avoiding deterioration by commoditization or competitors.
Companies leverage the above to maintain a strong level of demand. Using the cost leadership examples provides a clear view into how scale can maintain demand.
Barriers to entry and high switching costs help preserve pricing power. By protecting their business and offerings, through synthetic or structural switching costs, they can maintain healthy margins on the business.
Certain markets will eventually be commoditized, regardless of the market participants. The firms that hire talent and build a culture that enables change will be best positioned to adapt as necessary.
Ultimately, the desired outcome is durability.
Closing
A company’s moat is the unique combination of advantages that can lead to sustained performance over time.
Throughout the article I used examples to illustrate certain real-world applications. Many of the companies mentioned have multiple advantages at play.
Intuitive doesn’t benefit only from regulatory requirements. To operate machines for robotic surgery requires training and certification. Doctors throughout the world are getting certified and trained on the Da Vinci, their primary product. The training programs, education, and ensuing job requirements provide a strong network effect that will be difficult to overcome, even if there were another suitable competitor. Intuitive is well positioned to capture value through their business model, focused on selling reusable parts required for each operation. Additionally, Intuitive continues expanding the use cases and abilities of the Da Vinci platform.
These types of powerful dynamics allow for a long-term durable business, one that can continue to grow and create value while protecting their pricing power for many years out.
Torre Financial is an independent investment advisory firm focused on emerging and established compounders.
Federico Torre
Torre Financial
federico@torrefinancial.com
https://torrefinancial.com
https://torrefinancial.substack.com
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