Like castles, companies need to have a defense line in place to fend off invaders. The economic moat, which takes its name from the water in its namesake, is a long-term, sustainable competitive advantage that prevents others from gaining market share. On the other hand, are they just passive, lazy strategies that avoid innovation?
What is an economic moat?
A moat is a long-term advantage that can be compared to a competitive edge. A canal can be long-term, while a competitive edge is merely a window of opportunity within a business’s journey.
The types of moats will be discussed, but the common characteristics of a business that has a canal are that it is cash-rich and that it generates strong returns. These moat-like tendencies are characterized by high levels of free cash flow and a positive Return on Invested Capital (“ROIC”) minus the weighted average capital cost (“WACC”). The former indicates that the company is generating money, which can be used to strengthen its moat. And the latter shows that it is using its money in a more effective way than its competitors.
Morningstar, a leader in moat thinking, has even created an index that includes a basket full of moat stocks. The ETF, which replicates the group of premier companies, outperformed the S&P 500 for a sustained period.
It is interesting to note that health care is the most prevalent sector in the Moat Index. Health strategy is a complex field, and there are many attempts (despite some misguided) to disrupt it. This would justify a series of articles. When you read about intangible assets, you will learn how to build moats within healthcare.
Low-cost production
A company that can produce at low costs will be able to perform better than its competitors. The producer can capture more profit or gain more market share by offering attractive prices. This is the most important moat in “commodity industries,” as customers will be more agnostic if there’s a high degree of homogeneity to the product or service.
These characteristics are becoming more common in cellular phones. Years ago, the features and aesthetics of each OEM’s phones would define a phone. Only large OEMs that aren’t Google and Apple can compete with the operating systems that power phones. Andy Rubin, the creator of Android, was unable to overcome this challenge. His new phone company, Essential, spent over 100m in 2017 developing the device, but sales were barely noticeable.
In general, low-cost advantages come from large-scale operations, where automation and bulk-buying reduce overhead. It’s an advantage gained through process expertise and sometimes by capturing geographical or capital cost arbitrages. Take three Middle Eastern Airlines, Etihad Airways, Emirates, and Qatar Airways. They have all grown to be very prominent in recent years. Due to government subsidies, their capital costs are lower than those of pure-private airlines (over 42 billion since 2004, and their geographical location offers an excellent advantage in terms of price for hub-and-spoke routes.
Focus on these areas to gain a competitive advantage in terms of cost:
Outsource only when necessary
Vertical integration can make a company appear more organized and elegant. If someone else is able to do a job more efficiently and at a lower cost, then you should consider outsourcing. A robust cost accounting system and full visibility of your supply chains should reveal such opportunities.
Be patient. Specialize on a smaller scale to reach broader scales later.
Startups are often ambitious to do everything. It leads to a generic approach that does not excel in anything and doesn’t provide a scale advantage. Once you have proven your success, become an expert in a single focus area.
Japanese management techniques
When first introduced to the world, Japanese organization Principles opened new perspectives on management. Kaizen (improvement) and Kanban (delivery) are two examples of ‘continual’ in the sense of small steps or changes, which, over time, create a more cost-effective process.
Switching costs
The deeper the moat around an incumbent, the harder it will be for customers to switch. This cost is a combination of price, inconvenience, and risk, as well as the time needed to change platforms. This type of lock-in is a moat, as it increases a customer’s lifetime value and builds up a unit economy advantage.
When switching costs are discussed, they’re often related to poor customer service. The hoops that must be jumped through to get out of a utility contract or change banks, for example.
The topic of switching costs is a hot one these days because I believe that there has been a shift in the alignment in favor of consumers. Technology advances have made it easier for consumers to switch. For example, terminating a mainframe contract physically is much more difficult than whipping to Amazon Web Services. The switching costs are now exogenous for consumers. Their data and behavior patterns increase their earned utility, which keeps them with the service against their will.
Consider, for instance, a Netflix customer who is considering a switch to Hulu. There is no physical cost to switch, but the customer would lose years of data-matching behavior patterns that are reflected in the customized recommendations Netflix offers. Data moats have replaced switching costs as a major concern.
The most popular topic in economic moats is switching costs. Open Banking, GDPR, and other regulatory initiatives are, in essence, initiatives to liberalize data portability.
Look at the following to encourage behavioral switching costs exogenous in an organization:
Data is precious, both for its creation and storage.
Build your platform instead of putting layers on top of each other. Ownership of your data provides more flexibility, insight, and protection against risks. It’s because they want to own their data and not be like Meerkat.
Invest in data sciences and integrate them with the marketing and commercial teams.
Erik Stettler, in a recent article, wrote: “Information is the most valuable commodity on earth. But data is not information”. Data is not information, as Erik Stettler wrote recently.
Have a process in place for identifying and responding to lost customers
You may have seen the generic “why did unsubscribe?” pop-up or experienced the dreary exit interview after leaving a job. Sometimes, they can seem like a way to get somewhere. Do not be afraid to acknowledge and celebrate your insight in identifying the reason a client left.
Network effects
The concept of network effect is one of the most common buzzwords in business today. It is misused and misinterpreted. In its most basic form, network effects occur when a business’s users receive more value with the increase in users within the ecosystem. It indicates that users are compatible and gain increasing weight. The company creates value both for themselves and for others as it facilitates this. This is the perfect economic moat.
Aggregator and platform types of businesses are particularly interested in creating network effects. Social networks and on-demand business models have brought this term to the forefront, but it has always existed. Think of hobby clubs, telephone switchboards, and old-fashioned marketplaces.
When you consider the value and cost of increasing users, it is easy to understand why network effects can be moats. The facilitator’s marginal cost, assuming that the scale is reasonable, barely increases as users increase, but the value created quadruples.
