As investors, we are constantly on the hunt for the next business to add into portfolios. But before we make any purchase, it would be prudent and wise of us to ask ourselves this question:
Does the company that I am about to buy have any economic moats or a Durable Competitive Advantage?
2. What is an Economic Moat?
In the first place, what is an economic moat?
This term has been coined by world renowned investor, Warren Buffett, when he looks at the competitive advantages and the sustainability of a potential investment.
Simply put, an economic moat is what helps the business thrive over their competitors. The concept is that businesses should have some defensible characteristics so that it can continue to churn profits while fighting off competition.
Source: Google Images
The picture above would be used to illustrate the function of a moat.
The castle is being surrounded by a moat so that its enemies will not be able to encroach into it. Some kingdoms may decide to further enhance the moat by putting crocodiles in it so that its enemies cannot even swim over to the other side. In other words, the castle is very heavily defended.
3. Types of Economic Moats
In business terms, companies that we invest in should have economic moats. Here are some examples of an economic moat:
- Pricing Power
If there was one trait that all of Warren Buffett’s companies possess, it would be pricing power. The billionaire has mentioned before that pricing power is one of the most valuable characteristic that a business can have.
Pricing power is the ability of a company to raise prices on goods and services without losing its customer base. Take Apple (NASDAQ: AAPL) for example. It has raised prices on its devices year over year and consumers are still flocking over to its stores despite having a cheaper alternative.
On the other hand, a business does not possess pricing power when it cannot raise prices on its goods. Airline companies have a reputation for operating in an industry that is extremely price sensitive. Consumers tend to scout around for the lowest price on airfares before making a purchase. In order to remain competitive, the industry has been lowering prices on its products in order to keep its customers coming back.
- Economies of Scale
The textbook definition of economies of scale is this: A business is said to have economies of scale when the cost per unit of output decreases with increasing scale. This is because the fixed costs are spread out over a larger unit of goods and services.
Economies of scale can generate significant barriers to entry especially when a company operates in a capital intensive industry. Companies that possess this trait would be Wal-Mart (NYSE: WMT) and fellow online retailer Amazon.com (NASDAQ: AMZN). By being able to make bulk purchases from its suppliers, these companies are able to get the cost of goods down to prices where is not available to other competitors. Despite compressing their margins, Wal-Mart and Amazon.com has been able to compete in a cut-throat industry thanks to their economies of scale.
- Habit-Driven Products
One of the best businesses to own, in my own experience, are those that sell products which encourage habit-driven use and purchase. The nature of Starbucks’ (NASDAQ: SBUX) product, which is mainly coffee, encourages consumers to repeatedly purchase them on a daily basis. With repeated sales and a habit-driven purchase, Starbucks can easily raise prices on their coffee and thus, reward shareholders in the long-run.
The same can also be said of tobacco companies such as Altria (NYSE: MO) and Philip Morris (NYSE: PM) although some may argue that these companies should not render our investment base on moral grounds. I believe that we need to figure out which investment will suit our beliefs and convictions before putting our dollars in those companies.
- Network Effects
As I look into my own portfolio of stocks, I was surprised to find that so many of the companies that I invest in possess this moat.
TripAdvisor (NASDAQ: TRIP) and Facebook (NASDAQ: FB) are companies that enjoys this advantage. The network effect is that powerful and sustainable dynamic whereby each new consumer adds more value to every other consumer of the service. These businesses usually have a strong branding amongst consumers and enterprises which in turns protect them from new entrants. As the number of customers increase on their platform, it will in turn attract more enterprises to use the site and hence, repeat the positive cycle.
Other examples would include MasterCard (NYSE: MA) and its larger rival, Visa (NYSE: V). Both of these companies act as a matchmaker between consumers and merchants. As more consumers use the products, more merchants are inclined to adopt the payment system. And the positive cycle goes on and on, creating a steady moat around the business.
Think about the businesses in your portfolio.
Are you able to identify stocks that have one or a combination of the economic moats mentioned above? It is extremely critical that the companies we invest in has more than just a huge market opportunity or great financials. Because it will not matter if it does not have an economic moat to protect itself from competitors; at some point, one would come and undermine its success and that should worry you.
If you want to learn more about how to find Great Companies with Solid Economic Moats to Generate 3 Sources of Passive Income for you, click on the picture below to join our Free Value Investing Masterclass …..
Research Analyst, Mind Kinesis Value Investing Academy
Disclaimer: Please note that all information stated in this article is just for education purpose only and should not be used as any form of recommendation or advice.