Moats have been used in medieval history to protect a castle from marauding invaders. Some of these moats are deep and filled with water, while others may have large alligators in them to scare enemies away and discourage them from approaching the castle.
Using that analogy, an economic moat can thus be described as a business’ ability to protect itself from competitive onslaught to maintain its competitiveness and to sustain long-term profits.
The book “Why Moats Matter” from Morningstar is a good read and details the various types of moats which an investor should look out for. There are five main types of moats – intangibles, high switching costs, network effect, cost advantage, and efficient scale. However, intangibles itself can be broken down into i) brand; ii) patents; and iii) regulation.
Intangible – Brand
Some brand names are popular across the world, and most people would immediately recognise them. However, what’s important here is for the brand to confer an additional benefit to the company, in the form of increased pricing power due to a preference for the brand’s products or services. Brand alone is not a sufficient consideration as a moat if it does not generate a return on invested capital which is superior to other firms within the same industry. A brand also has value if it increases customer captivity, meaning customers are more willing to purchase from the company as opposed to its competitors.
Intangible – Patent
Patents are granted to companies with inventions or innovations and essentially protect the company from competition for a specific period. During this period, the company can exclusively produce and sell its product and thus enjoy higher than normal returns, as the patent grants it a form of monopoly. For investors, they should note the expiry date for the patent and also how strong the patent is in relation to the product/service being sold. Some competitors may go around the patent and create a very similar substitute product at a lower price, thus diluting the benefits from the company’s patent.
Intangible – Regulation
Regulations are a set of rules and laws implemented by the government or various authorities which prevent other competitors from entering a market or selling certain products/services. While regulatory moats can be powerful, the investor should check on whether these come tied to price controls or service mandates which may cap the upside potential for profits. An example may be a company being granted a concession to operate the only water treatment utility plant in a country, but the flip side is that the tariffs they can charge are capped by the government to make the treated water more affordable for businesses and individuals.
Watch out for Part 2 where I will cover the remaining four types of moats. [Editor’s note: The article on the remaining types of moats has been published and it can be found here.]
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.