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Why A Competitive Advantage May Not be Enough

A competitive advantage can be referred to as the “economic moat” of a company. Like a moat around a traditional castle, the phrase refers to the ability of a business to defend its profits from its competitors, and where possible, expand its market share. It follows that if a company is able to dig a strong, and sustainable moat around its business, it might just possess the comparable advantage to drive equally strong profits around it.

However, is an “economic moat” alone enough to create value for the business?

A lesson on the economics of a “moat”

Sometime in late 2006, I bought shares of a US-based company called Walter Industries. At the time, the company owned 75% of another company called Mueller Water Works. Mueller Water Works was a 100-year-old business which manufactures anything from hydrants, to valves for piping systems. The business had high barriers of entry for its competitors as its customers could take up to five years to certify its competitor products for use. In other words, it had a “moat” around its business.

At the same time, water infrastructure in the US was decrepit, and in need of upgrades. Estimates at the time, put potential spending on waterworks at a range of US$60 billion to US$200 billion over the next two decades. When we put the large addressable market of US$60 billion to US$200 billion, and the “only-me” position of Mueller Water Works, it seemed like a shoo-in for nice returns for the future.

However, keen-eyed Foolish readers may already spot the problem with this thesis.

As it turned out, there was little appetite from the US government to upgrade its pipes. This was made worst by the start of the Great Financial Crisis in late 2007. As a result, Mueller’s revenue drifted down from US$1.9 billion in 2006 to US$1.3 billion in 2013 as the addressable market did not come to pass.

Value from an economic moat

To be sure, figuring out the “moat” of a business is important.

However, my experience with Mueller Water Works taught me that I should not be too caught up with thinking of “moats” alone. It turns out that the value that a company can derive from its “moat” can be equally important. Said another way, when your customer cannot afford your services, or have less need for your services, there are significantly less value that your “economic moat” can gain.

Economic Moats in Singapore

I have written in the past about how SGX-listed companies such Japan Food Holdings Ltd (SGX:5OI), and Sakae Holding Ltd (SGX:5DO) may have some of the strongest gross margins in the Japanese food and beverage industry. This strength in terms of lower cost might represent a “moat” for both companies.

However, as Foolish investors, we might want to think a few steps further to consider if there are other possible threats which prevents both companies from taking advantage of its “moat”. These threats may include the possibility of Japanese food getting less popular over time, or if there are instances where new cuisine from Korea or Vietnam may compete strongly for the same consumer dollar.

Foolish bottom line

In my mind, there are two parts to looking for a competitive advantage or “economic moat”. The first would be to identify the comparable advantage or the “moat”, followed by how this advantage will benefit the business. The second part would be the “economic” side of deriving value from the moat. Both steps might be critical for an investment to be successful.

Deriving value from a competitive advantage may not alway be as straight forward as thought. As the business analogy goes, being the best buggy whip maker in the late 19th century would not have helped if the future was going to be automobiles.