Equity market investors often fancy a moat around the businesses they invest in, so that their investment stays protected. Competitive advantage is something which investors are longing for big time.
One thing that becomes really important to checks however, is the competitive advantage sustainable in the current environment, where everything is changing so fast?
Are the traditional competitive advantages still to be looked into while investing?
Let me Start.
What is Moat (Competitive Advantage)?
A deep, wide ditch surrounding a castle, fort, or town, typically filled with water and intended as a defense against attack.
Popularized by Warren Buffett, refers to a business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms.
Warren Buffett on moats
“(Great companies to invest are like) wonderful castles, surrounded by deep, dangerous moats where the leader inside is an honest and decent person. Companies that are low-cost producers or that own powerful brands. The most important thing [is] trying to find a business with a wide and long-lasting moat around it… protecting a terrific economic castle with an honest lord in charge of the castle.”
Justifying the above Buffett’s quote I would say that there are two important aspects to be kept in mind while judging a moat;
- The Depth
- Longevity or Durability
But if the moat shrinks and disappears, a buy and hold strategy will not save you.
So how Durable the Moat Is?
- A high return on capital in the past is a necessary, but not a sufficient condition to demonstrate the presence of a moat. It is also important to judge the depth and longevity or durability of moat.
- If your estimate is correct and turns out to be higher than that of the market, then you will make excess returns. If not, be prepared to lose money or at best make market level returns. As a corollary a buy and hold works only if you get the durability aspect correct. If the moat shrinks and disappears, a buy and hold strategy will not save you.
In a nutshell, can you visualize whether company’s product/services shall be in demand 10/20 yrs down the line?
Primary elements that can help create a moat
- Supply-Side Economies of Scale and Scope
If a company’s average costs fall when more of a product or service is produced, there are supply-side economies of scale.
E.g. – Intel, Wal-Mart, Relaxo – In FY18 relaxo sold 15.7 Cr pair compare to 13.5 Cr pair in FY17, if we calculate operating profit per pair it is increased by Rs. 19.24 in FY18 compare to Rs. 17.11 in FY17.
- Demand-Side Economies of Scale (Network Effects)
Demand-side economies of scale (also known as “network effects”) result when a product or service becomes more valuable as more people use it.
E.g. – Info edge – Naukri business which is synonym for the people looking for job,
MCX – Commodity trading, VISA – Debit card & Credit card.
Think Coke, Nike, Disney, Costco, and the like. The brand is one of the hardest moats to describe, but you know it when you see it. The creation of the brand is a rare thing, and it requires great skill and a large dose of luck as well.
E.g. – Nestle, Royal Enfield, Titan
When we want to buy Noodles; we don’t ask for noodles in the shop we say Maggie (that’s BRAND).
- Patents and Intellectual Property
Companies that have been granted a patent, trademark, or other type of intellectual property by the government have in effect been given a legal monopoly. This barrier to entry can create a substantial moat for the owner of the intellectual property.
E.g. – Jubilant Foodworks ltd operates Domino’s Pizza brand with the exclusive right for India, Nepal, Bangladesh and Sri Lanka.
- Switching Costs
The cost of switching to a competitor outweighs the cost or product benefits of a new and better product.
E.g. – Oracle, Accelya, Infosys (Finnacle)
Software ones installed is difficult to switch as training associated, they friendliness restrict the cost of changes.
What makes this element Fade away?
- First factor is the increased flexibility with which we accept change (Adaption). Thanks to Technology.
- Another factor is the ‘rate of change’; almost everything under the sun can be/is being disrupted by Innovation.
E.g. – Multiplex Industry in US
- After the entry of Netflix and Amazon Prime, streaming services have made it more convenient to watch movies and TV programmers anywhere, on internet-connected TVs, tablets and smart phones.
- For us in India, while the situation may not play out like to like in near future, given US screen penetration is at much advanced level VS India; however it would play to keep a tab on such trends.
Tony Robbins on Innovation
Innovation is any way you find a way to do more for a client than anybody else does. There is only one way to get wealthy, it’s fall in love with your client and not with your product or service, because your product or service is going to have to change.
Time is going to change your product. I don’t care how long it’s been around. What used to take time—centuries, the iron age, the ice age, thousand-year periods of time—started happening in centuries, then started happening in decades and now what’s happening?
We’re doubling the amount of information that man has on the planet, digitized even, every 36 months. The changes are geometric and we’re at the beginning of the beginning of the beginning of the pace of change.
To look at how convenient innovation has made our life, check this video Evolution of Change – 1980 to Present
Traditional businesses are linear business model
What is linear business model?
- Companies created a product or services and sold it to the customer
E.g. – Walmart, Maruti Suzuki
The company creates a product and sells it to group B (a distributor), who then sells it to group A (the customer).These businesses create value and distribute it efficiently to their target customers. They achieved this efficiency via the supply chain, a highly structured system for organizing activities and resources that moved a product or service from the company to the customer. The supply chain is also linear, consisting of processes that are repeated over and over again to create value.
For example, a car manufacturer like Maruti Suzuki buys parts from its suppliers, which in turn may have bought parts or raw materials from another supplier. Maruti Suzuki then takes these parts and creates a finished product, in this case a car. From there, Maruti Suzuki sells the car to a dealership, which finally sells the product to a consumer.
Disruption of Moats – Search Cost (Amazon Batteries)
At each step in the supply chain, someone adds value to the product or service and then moves it on to the next link in the chain. However, the efficiencies of the supply chain approach come at a cost. Linear businesses require large factories or investments in human capital and elaborate distributions channels in order to create products and move them to market. In the twenty-first century, the supply chain is no longer the central aggregator of business value.
Amazon’s private-label program has become a major threat to big brands in certain categories. Amazon controlled a whopping 94% of the approximately $113 million in online battery sales. Amazon Basics private label had a 31% share of online battery sales, while Duracell had a 21% online share.
Duracell is well known brand in batteries. But, where the brand is only search cost as soon as it touches alternative people shift. Duracell brand is relying on trust previously as no better option available.
As Amazon has a trust factor in people mind for them it’s easy to scale there market. Consumption of such product doesn’t require social acceptance.
Amazon Basic Battery has such a spotlight in consumer mind that competitors are advertising against Amazon to put their product as a priority while searching on Amazon. Still Amazon product is preferred in online because customer is not willing to pay extra for brand with low search cost.
Disruption of Moats – Network Effects
|“People often mistake technology for a static picture. It’s less like a picture and more like a movie. It’s the velocity of technology innovation that matters. It’s the acceleration.”
– Elon Musk
Blackberry VS Apple
BlackBerry became the leading Smartphone, famous for its reliability and security as well as its iconic QWERTY keyboard. BlackBerry Messenger application also was a major Hit. By the end of 2006, the BlackBerry had nearly 40 percent market share in the United States.
On January 9, 2007, Apple launched the iPhone. Blackberry management saw the iPhone as an inferior product. Company believed that its superior hardware would win out.
What went wrong for Blackberry?
Consumers just left in droves because they couldn’t find many apps on a BlackBerry handset compared to an Apple or Android device. BlackBerry devices didn’t offer anything like web browsing or applications, and nobody wanted to develop for it because there were no customers there.
When the iPhone launched, they didn’t transform the business quickly enough. A similar thing happened to Nokia. They didn’t catch onto the popularity of touch screen technology and they stuck with the keyboard. It made BlackBerry products look outdated. It was a dying factor when so many people found touch screens more practical.
Now networks connect businesses and individuals, enabling them to exchange value among themselves.Networks are the new aggregator of business value, when the world becomes more connected; what a company owns matters less than the resources it can connect to.
In the old model, scale was a result of investing in and growing a business’s internal resources. But in a networked world, scale comes from cultivating an external network built on top of your business.
E.g. – Google reduces the cost of finding a Website; Paytm reduces the cost of sending digital payments, Zomato connected individuals to other individuals so that anyone could buy from or sell to anyone else.
Rather than building inventory and resources, Paytm provided the digital infrastructure for this market place to exist and helped build the community around it.