How To Tell If A Company Has A Moat

Here are 8 ways a company can create a moat

February 27, 2023

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Now for today’s piece:

How To Tell If A Company Has A Moat

Highlights

If you only have a few minutes to spare, here are some helpful tips to help you identify a company’s moat:

 

• Moats can be identified by looking for high switching costs, high barriers to entry, brand ecosystems, unique products, pricing power, brand loyalty, efficiency, and location.

 

• Examples of companies with moats are Apple, Starbucks, and ASML.

 

• Companies with moats can have an advantage over their competitors.

 

• Not all companies have moats and some may be difficult to identify.

 

• It may be difficult to judge the size of a company’s moat.

What Is A Moat?

A moat is an economic term for describing a company’s competitive advantages.

The term moat was made famous by the great Warren Buffett and much like the moat around a castle protects from intruders, a business’s moat protects itself from competitors.

When identifying moats, there are 8 competitive advantages I often see contributing to a business’s moat.

We’ll explore each of these 8 advantages further:

High Switching Costs

Switching from one business to another is often a very costly process.

Imagine you owned a company and you employed the service of a cybersecurity company. If you’re paying a company to manage sensitive data, it's very unlikely you’ll want that info to change hands. These relationships remain “sticky” in a sense.

You as the business owner are less likely to switch to a competitor because of the time and resources you’d have to spend.

And that burden of switching provides a competitive advantage for the cybersecurity firm.

High Barrier To Entry

Is it easy or difficult for a competitor to join this marketplace?

Some industries are naturally hard to break into, like the railroad industry in the US.

Here in the US, the railroad system is not nationalized like many other parts of the world. Land must be purchased for the tracks and that precious land is finite.

Not only does the land have to be bought, but any would-be competitors will have to spend years building the tracks.

Then after building the tracks, these competitors would have to compete for customers in an industry where many clients aren’t looking to move their logistics around.

If you were starting a new railroad company in the US, it would be extremely difficult just to join the industry.

Brand Ecosystem

Does the company have an interconnected ecosystem of goods and services?

Think of Apple’s product offering.

They have physical devices such as phones, tablets, computers, and wearables. In addition, they have subscription services like Apple Music, Apple Fitness, Cloud Storage, and so on.

Once you’re integrated into Apple’s ecosystem, it becomes very difficult to stray away. You become accustomed to all the connected features Apple offers.

Unique Products

Does the company offer unique products? Are they easy or difficult for competitors to copy?

This is why I tend to stay away from investing in social media companies. It's extremely simple for Instagram to copy Snapchat’s idea of stories or for Facebook to implement TikTok’s short video style. These products are too similar for me to invest in and the competitive edge is slim to none.

On the other hand, I look for companies with products that are very difficult to replicate.

The best example I can think of is the EUV lithography machines made by ASML. You can check out my full breakdown of the company here but in short, their machines require over 10,000 parts and those parts are often made by a handful of companies, most of which ASML owns. Each EUV machine has over a decade of R&D and it's extremely unlikely a company could replicate that product.

Pricing Power

Pricing power is the ability of a company to raise prices without having demand suffer.

Companies may do this to pass on inflationary costs to consumers or to increase revenue in order to offset spending.

A great example of a company with pricing power is Starbucks. 2022 was a year filled with supply chain problems and inflationary pressures. Starbucks was able to raise menu prices THREE times to combat these problems.

Demand is still strong for the brand and Starbucks was able to weather the storm.

Brand Loyalty

Brand loyalty can give companies a competitive edge.

I’ll use Apple again in this example. Over the past few years, Apple’s iPhones from year to year haven’t been dramatically improved upon. While that may be the case, Apple has had no problem selling out of stock each year.

Why?

Brand loyalty.

People will wait on the edge of their seats for new Apple products and the second they’re released, they’ll form a line at the store to get their hands on them.

Apple is the same company that can get away with selling microfiber cleaning cloths for $19. They know they have loyal fans and they can charge above-average prices as a result.

Efficiency

Efficiency can be a huge competitive advantage for businesses.

If 2 companies sell similar products and 1 company can achieve higher profit margins, that company is likely running more efficiently.

A company operating more efficiently can lead to higher profits, more productive staff, and happier customers.

A win-win for everybody.

Location

You know the famous phrase, “Location, location, location.”

Sometimes location can be enough to put a company on top of its competitors. This is especially true for Real Estate Investment Trusts (REITs). Imagine there are 2 REITs that are involved in the entertainment industry. They each want to own casinos, hotels, and conference venues. One company buys property in Las Vegas, Nevada, and the other company buys property in rural Montana.

Which company should perform better?

The first company should perform better, it owns entertainment property in the city where people around the world flock for entertainment.

It doesn’t matter if the second company has better buildings or entertainment, it's not in the right location to take advantage of its offerings.

Final Thoughts

When evaluating the competitive advantages of a company, it is important to consider how these advantages will contribute to the overall moat of the business.

There are a variety of different factors that could lead to creating a strong moat, ranging from efficiency to brand loyalty, and it is possible for a company to have more than one of these advantages.

However, while it may be relatively easy to identify a moat, it can be more challenging to accurately judge the size of it. I find it beneficial to revisit my investing thesis at least every quarter to ensure that the company is still on track to meeting my expectations.

Moats can take years to build, but if the company does not have the necessary resources in place to fuel its growth, that moat could quickly become a thing of the past.

I hope this guide helps you identify companies with wiiiiiide moats.

Happy Dividend Investing!

Sincerely,

Dr. “Moat Finder” Dividend

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