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Economic Moats: An Important Driver of Long-Term Returns

The concept of an Economic Moat was initially formulated by the renowned investor Warren Buffett and it simply refers to the competitive advantages that a company enjoys over its rivals in the same industry.

Companies with economic moats can usually protect their profits from competitors as they have businesses with characteristics that prevent others from snatching away those profits. Here we will be discussing three common economic moats that investors can use to think about companies that they might want to invest in.

Moat # 1 – Elevated costs of switching

This moat works on the principle that substituting a company’s product or service with those from a competitor can be so costly – in terms of retraining costs and implementation costs – that it seldom ever happens.

A good example is enterprise database services and software. Migrating from an existing enterprise database system to another could entail the risk of knocking out all essential services if the switch isn’t handled well. Besides, such a move can be a brutally costly and complex procedure. In light of that, it’s easy to see why customers tend to stick with such services once implemented. When companies get sticky customers, it’s easier to derive sustainably high profits for years to come.

Moat # 2 – Intangible assets

Intangible assets are a form of competitive advantage that can be further separated into two categories: government licenses and  branding power. Firms that acquire special government licenses enjoy an exceptional advantage over competitors and in a way enjoy a government granted monopoly in the market.

For instance, in 1992, mail delivery outfit Singapore Post  (SGX: S08) acquired exclusive rights to deliver mail within Singapore for 15 years. Although the rights expired in 2007, Singapore Post has already established a strong foothold for itself over the years in terms of both branding and business-volume.

Moat # 3 – Network effects

Companies like Facebook, Visa and Mastercard are great examples of firms that have a strong competitive advantage stemming from network effects.

For instance, social networking site Facebook’s popular among users because there are so many others using the service – 1.2 billion monthly active users – and it allows people to connect with one another half-way across the world.

With the credit card providers, Visa and Mastercard, their service is very valuable for merchants worldwide because so many consumers carry them. At the same time, Visa and Mastercard credit cards are so useful for consumers because so many merchants accept them. For new entrants, it’s hard to break into the cycle as they can easily run into a chicken-and-egg problem: How should they convince merchants to accept a credit card that has a small user-base while at the same time, convincing users to use credit cards that only a small number of merchants accept?

For a local context regarding network effects, we could look at Jardine Cycle & Carriage (SGX: C07), even though the presence of a network effect in the company might not be as obvious as compared to Facebook, Visa, and Mastercard. But, it’s there nonetheless.

Jardine Cycle & Carriage distributes more than 50% of the cars in Indonesia through its 50.1% ownership of Indonesian conglomerate Astra International. With such a wide distribution reach, it makes Jardine Cycle & Carriage’s distribution services more valuable for both consumers (through a wider selection) and car manufacturers (through the ability to reach a large number of potential car-buyers).

Foolish Bottomline

All told, the evaluation of the existence of any economic moats can be a key step when it comes to thinking about a company’s ability to deliver consistent returns over the long term. At the same time, it’s also good to note that economic moats are not constant. Investors also need to be aware of the on-going changes in the business, economic, and consumer behaviour landscape which may erode the sustainability of any moat.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor James Yeo doesn’t own shares in any companies mentioned.