INSIGHTS

A key marker of a quality company is what is often referred to as its economic moat, in other words its sustainable competitive advantage. In this article we discuss the concept of an economic moat and the factors that may give rise to it.

What is an economic moat?

An economic moat describes a company’s long-term sustainable advantage over its competitors. Think of a company as a castle surrounded by a moat, with the moat being the factors differentiating the company from its competitors, allowing it to out-compete them over the long-term. The ‘wider’ the moat the better.

In the classic economics textbook model of market competition, a company earning high profits will entice new companies to enter the market. This increased competition will ultimately drive down prices and eliminate these high profits. Back in the real world, an economic moat is essentially the combination of factors that prevent this process from occurring, ensuring the company can maintain its market leading position and earn higher profits into the future.

Generally speaking, companies with wide economic moats tend to be of a higher quality. We focus heavily on a company’s quality, believing these companies are more likely to provide superior returns over the long-term.

What may give rise to an economic moat?

There are many factors that may lead to a company having a wide economic moat. These include:

• Intellectual property. These could include patents, trademarks (brands) or research and development capability. For example, Fisher & Paykel Healthcare’s patents and research and development capability (such as the technology controlling humidity levels) have enabled it to build a strong business in hospital respiratory care. A brand that resonates with consumers, such as that built by Apple over many years, can also be a source of competitive advantage.
• Economies of scale. A good example of this is EBOS Group’s core pharmaceutical distribution business Symbion, which holds a dominant position in Australia and New Zealand. Due to its scale, EBOS is able to offer a better service at a lower cost to its customers. Due to the high upfront costs involved (building large distribution centres), this is very difficult for smaller competitors to match.
• The network effect. This is the idea that as the number of users grow, a business becomes more valuable and harder to displace. Platform businesses, like Amazon’s marketplace, illustrate the network effect clearly. Due to the large number of buyers and sellers already using the site, consumers know they are likely to get the greatest selection and the best deal on the site. This makes it very hard for a rival with fewer products and users to grow disrupt Amazon’s business.
• High customer switching costs. A customer is much less likely to switch products if doing so is painful or inconvenient. Possibly the best example of this is the Microsoft Windows operating system and the Office suite of products (like Excel and Word). Switching away from this system requires a steep learning curve and may cause compatibility problems with other people or businesses who continue to use Microsoft’s products.

A note on monopolies

Of course, a company operating in an industry which is unable to sustain more than one operator is in a position of power. Such ‘monopolies’ are often the subject of economic regulation to ensure that the returns the company earns are similar to those it would earn if the market were competitive. Examples of companies that are subject to some form of economic regulation are Vector and Auckland Airport.

While this regulation does reduce profitability, it also creates a very high barrier to competition and highly predictable earnings. This, along with other factors such as some parts of the business not being subject to regulation, means that these businesses can still be very attractive investment options.