This is a continuation of a series of articles on competitive moats as adapted from the book “Why Moats Matter” from Morningstar. Part 1 can be found here, and I covered the main aspects of intangible moats back then.
In this article, I will be touching on the four remaining moats – switching costs, efficient scale, cost advantage, and network effect.
Switching costs represent the costs and effort needed for a customer to switch from one supplier to another.
The higher the switching cost, the more reluctant the customer would be when it comes to changing suppliers, as this may involve considerable hassle as well as disruption (if it is a service).
A good example would be banking software companies which provide core banking systems to clients, most of whom may be large national banks. Once the software is installed and training provided to all staff, it would prove extremely disruptive and costly to effect a change in vendor, even if a vendor may provide a superior system and functionality.
The network effect is one of the most powerful moats in business and is very difficult to displace. The effect makes a service more valuable as it increases in size and scope as the value of the services provided grows as the number of users on the platform goes up.
This effect is most pronounced for internet-based businesses which allow transactions between buyers and sellers, as well as social networking sites. It becomes a virtuous cycle when more people sign up on the platform, making it more attractive and desirable, which then attracts even more people.
Cost advantage refers to a company which has a distinct and sustainable cost advantage over its rivals, such that it can continue to produce its goods more cheaply compared to its competitors.
Possible reasons for the cost advantage might be the location of factories (access to water or close proximity to mineral resources, hence lowering transportation costs), better terms with suppliers (bulk discounts) or process advantages (being vertically integrated).
This is a relatively new moat which was defined only in 2011 by Morningstar. It describes a situation where a firm or group of firms serve a unique and niche segment, such that it would be uneconomical for larger, more established firms to compete as it would drive down the overall returns for the segment, making all firms unprofitable. Such a moat must be carefully evaluated as there are not many such examples around.
In the next article on moats, I will be looking at moat trends, which discusses how and why some moats weaken or strengthen over time. [Editor’s note: The article on moat trends has been published and it can be found here.]
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