Assessing Competitive Moats

financial research, business financial research, marketing research, investment research, financial investing, learn about financial investing, investing, financial investmentsThe moat analogy

Another Buffett credit, the moat analogy works like this. A company’s assets are like a castle, with a surrounding moat to keep competitors from invading and looting its treasured advantages. In investing terms, competitive moats are well-stocked with special advantages that secure their market leadership, consistently outperforming competitors selling similar goods or services.

The more extensive the moat, goes the theory, the bigger and more secure the companies’ competitive advantage. There are several ways companies can build strong moats.

Well-Known, Established Brands

Perhaps the best example of this type of competitive moat is Coca-Cola and its long-term dominance in the soft drink industry. Coke, as a beverage, doesn’t offer consumers anything particularly special; moreover, competitors can easily imitate the product. To wit, there are many sugary, carbonated beverages on the market. Some emphasize their natural ingredients, small-batch process, and greater “artisanal” appeal. Others bank on lower price.

But in the hearts and minds of consumers, there’s still only one Coke. As a brand, Coke is simply “American,” as much as baseball and apple pie. Coke is linked with secularized Christmas and the winter holidays, whether it’s Santa Claus or a family of polar bears, enjoying a Coke, a smile, and merry tidings.

If Coca-Cola hadn’t entered business so early in the game, established itself as a symbol of authenticity and Americanness, and continued to improve on other competitive advantages, it might have gone out of business long ago. After all, its deep historical emotional connection with consumers is everything–because it lacks intangible assets that can fend off imitators.

Coke’s brand is its competitive moat. It consistently outperforms its competitors. Over the past 10 years, Coca-Cola has produced a solid earnings growth and a return on equity that has averaged 30%. Still, even companies with well-known, established brands–Blackberry, for example–are vulnerable to falling out of favor.

Intangible Assets

Take the case of Google, for example. A main feature of its competitive moat is its proven, consistent ability to attract the top talent in the industry, period. The secret: Google focuses only on talent.

Its hiring committees evaluate candidates almost exclusively on their past performance. They care about employees’ demonstrable excellence; they’re not especially concerned with whether or not they like you.

By hiring talented employees for talent’s sake, Google attracts the smartest, most capable candidates. If they don’t get along, fine. Something really smart might come out of arguments or competition. As Google Executive Chairman (and former CEO) Eric Schmidt himself says:

“You must work with people you don’t like, because a workforce comprised of people who are all ‘best office buddies’ can be homogeneous, and homogeneity in an organization breeds failure.”

Intangible assets can also be things like:

Exclusive or inexpensive access to natural resources, such as high grade ores or power, unavailable to competitors

Innovative, patented technologies that are either part of the product itself; used advantageously in manufacturing the product; systems that offer competitive aid in customer service, behavior; and so on. These companies often fill their moats with innovation to “disrupt” an industry with goods or services that are what the late Steve Jobs’s described as “insanely great.” But it can be tough to maintain an innovative technology moat because copy-cat competitors are never far behind, offering a lower price. Just ask Apple and Samsung.

Cost leadership, offering products or services at the lowest cost in the industry. But this moat strategy is tricky because companies are always at risk of operating at a loss, to stick to their brand promise. Just ask Walmart.

Any business practice that proves a company’s time-tested ability to maximize scale economies in products or services, while fetching premium prices.

But risk from competition is just one risk among many that we need to be concerned about. Another is Valuation Risk