High profits attract attention which makes more people invest and as a result the profit of companies decreases over time for most of the companies as competition comes in. There are companies who defy economic gravity by creating structural advantages, economic moats, insulating and buffering themselves against the competition and thus keeping super normal returns on capital for longer duration. There are four of types of economic moats or intangible assets.
Insight of intangible assets having effect on Economic Moats
The first being brands since being well known is not sufficient there needs to be a change in the consumer behavior by increasing the willingness to pay or reducing the search costs thus resulting in the increase of the value of the company. Brands can only be valuable if they are consistent and deliver an aspirational experience. Don’t make any unnecessary changes in the product as it may not be well received and many loyal customers might ought to switch the brand. Aspiration also plays an important and it is achieved by increasing the exclusive products and creating its scarcity.
The second being patents despite being legal they are subject to expiry, challenge and piracy and the moment a patent gets challenged the interest on capital is decreases therefore in order to rely on patents as a moat there is need of portfolio for them as it is hard to invalidate one or the other
Third being licenses or approvals as it is not easy to get a license or approval and it serves as a solid moat.
Restraints to try new businesses
Switching cost effect
Switching to competitive products is expensive and time consuming. Service relationships can be sold in the form of maintenance by attaching a service to the product and also by providing high benefit to cost ratio as it is more beneficial when switching business is being looked for.
The Network effect
By providing the service that increases the value of the company as the number of users expand and aggregate demand is increased between parties scattered at different places. As soon as the number of nodes and connections is increased the network becomes hard to replicate thus becoming a strong moat. There are two types of networks being radial and interactive. Radial networks are less effective and robust.
Process: By inventing a cheaper way to deliver a product that cannot be replicated quickly.
Scale: Spread fixed costs over a large base. Relative size matters more than absolute size.
Niche: Establish minimum efficient scale.
Role of Management
Managements plays an important role in moats. Managerial skills are inversely proportional to the quality of business. If the business is good, then average management would also do fine but for bad business a good manager is required. Good mangers look for ways to widen the companies moat and on the other hand bad managers invest capital outside company’s moat. It can be reduced by having the owner’s presence at the company and not leaving it in the hand of one of its staff. At the same time there are exceptions where a good manager can do good in bad businesses. There is also a fair share of chance in all these managements and trying new things.
Advantages of Moats
Moats can buffer the mistakes of management and save the business from complete disaster as it happened in case of Microsoft, New Coke because business was strong and robust. Local differences can create moats even like in Canada foreign companies are not allowed to own banks thus allowing Canadian banks to be more profitable. Minimum efficient scale is more common as big companies may not invest in small businesses thus giving complete ground to the small companies. Culture preferences also matter a lot since the things famous in one country might not do well in another country i.e food products thus allowing these businesses to build moats around them.
Moats matter a lot as it adds to the intrinsic value of the company. A firm which can compound cash flow for many years has more worth than the firm which cannot. Companies with no moats capital comes down fast as compared to the companies with greater moats. The value of an economic moat is also largely dependent on reinvestment opportunities. The ability to re-invest a lot of cash at high incremental ROIC would make it a very valuable moat by contrast if a firm has little ability to reinvest it would add a little to the intrinsic value of moat. Moats are not limited only to big companies in fact it can be beneficial in creating stability and building confidence.
Investing in moats
While investing in moats there are two things overestimating a moat which means paying for value creation that will never materialize as it happened after release of Moto Razor by Motorola. In case of underestimating it means there is a large opportunity cost it means that on finding a good business opportunity invest in it as it is going to compound at high rate in order to avoid the suffering of opportunity cost. Wasting time on margin of safety and not a lot on opportunity cost is the problem of a lot of investors. As far as the pricing of moat in business already is concerned most of the investors own securities for a short period of time and moats matter in a long run. Most of the investors assume the current state of the world persists longer than it usually does. Most investors focus on short-term changes in price, not long term changes in moats.
Finding economic moats means finding efficiency of business. The quantitative data in market tends to be very efficiently priced. Qualitative insight, understanding the structural characteristics of the business. All the information in the past, but all the value is in the future so the future value creation will come from the things you see today not necessarily the information that occurred in past. Hence the economic moats have a significant effect in keeping the organizations at top and it is a good for defense of an organization.
1 – Google Talk by Pat Dorsey on Economic Moats.