Investment decision should not be based solely on past numbers. Don't assume that an extremely profitable company will maintain its profitability in the future too. High growth companies often struggle to retain its profitability. The reason is very straightforward. Success attracts competition and the bigger the profits, the stronger the competition. If your highly profitable restaurant business attracts huge footfalls, then it is obvious that more restaurants will set-up around
you. Sooner or later it will become difficult to maintain the same profitability. Therefore, highly profitable firms tend to become less profitable over the time as competitors eat away their market share.
World's most successful investor, Warren Buffett once mentioned,
“In business, I look for economic castles protected by unbreachable moats. A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns.”
Now let's have a look at how companies create an economic moat. The most common way is to offer better product or service than its competitors. Customers don't hesitate to pay a little more for a better product or service. If you can differentiate your product from others, then you can charge a premium. Differentiating factors include features, technology, specification, durability, appearance or anything else. The problem is better technology or more features on any product are not sustainable for a long period. The reason is competitors will always try to develop superior technology or products. Further, it requires huge R&D expenses to develop constantly superior product. As a result, product will become costlier. A customer may be satisfied with a slightly better product at a significantly lower price. A market leader today may be replaced by its competitors who offer almost similar product with low price. Following example will further clear this point.
In mobile handset segment, Nokia was market leader almost in the last two decades (till 2009-10). Mobile handsets from Nokia were well known for its durability and quality. Nokia also charged a premium for its handset. Over the years, Samsung started manufacturing the almost similar product at lower cost. After that with the advent of Android operating system, Samsung overtakes Nokia and emerges as a market leader in the mobile handset segment. After the huge success of Samsung based on Android operating system, many local manufacturers are joining the league. Indian handset maker, Micromax started manufacturing almost same Android based handset as of Samsung with lower price tag. No wonder, it emerges as a leader among Indian mobile handset makers. Being a global player, it is hard to challenge leadership position of Samsung. However, Micromax is successful to increase its market share at the cost of Samsung.
Apart from real product differentiation, a strong brand name creates a perceived product differentiation in the customer's mind. The best part is that the product may not be superior to others, but customers will be ready to pay a little more due to that brand name. Building a reputed brand is time-consuming. However successful brand act as broad economic moat. It not only prevents to enter new players but also it prevents to expand the market share of its competitors.
A very common example is Apple Inc. Over the past decade, Apple charges a hefty premium on its iPhone and Macbook range. Over the last few years, I am using iPhone, which is 15%-20% costlier than the most expensive Android based phone. However, the premium of 15%-20% is just because of its brand name. There are no such significant differences in functionality. The logo of Apple is eye catchy, and it draws the attention of the crowd. Perhaps this is one of the most important reasons for maintaining numero uno position in the premium handset market.
Another well-known brand is Cadbury. It is the most loved brand among teenagers especially girls. Still I remember, 2-3 years back Cadbury Diary Milk costs only rupees 10, today it costs double. You will find that each and every year Cadbury reduce their packaging size to offer the same thing at a higher price. A slightly improved version “Cadbury Dairy Milk Silk” costs Rupees 50! Still this is the preferred choice among consumers. There are many other brands in the market that sells chocolates. In fact, Nestle also has a vast portfolio of chocolates. Still people prefer the brand Cadbury. Thus, it enjoys high pricing power and higher profitability than its peers.
However, it is not necessary that all brands can create a wide economic moat. There are many successful brands in Airlines Industry. However, it is difficult to have competitive advantages due to the nature of Airlines industry, consumer behavior and intense competition. Consumers always attract towards discount while booking airlines ticket. Thus, it's hard to retain existing customers.
Customer lock-in or creating high switching costs is one of the best and durable competitive advantages. Brands, better products, cost advantages all of them are relatively easier to spot out from outside, but knowing exactly what makes a customer lock-in to a particular product or service may be difficult to find out.
Switching cost refers to the factors that make difficult for a customer to switch to the products or service of a competitor. The factors can be in terms of money or time of convenience. If switching cost is high then customers won't shift to the competitor's product/service quickly. Thus, he company can easily demand premium from its existing customers.
It is very hard to find such business. I can co-relate with banking industries to some extent. It requires several documentation and time to open an account in the bank. After opening your bank account if you find that another bank offers high-interest rate in a savings account, do you immediately close your existing bank account? The answer is obviously “No”. Moreover, banks often charge a penalty for closing account within one year. Equity broking industry can also comparable. To open demat and trading account, it requires 10-20 days with lots of documentation. It is also difficult and costly to shift all existing equity holdings to the new DP. This is why investors don't change their brokers once in every year just for low brokerage. However if the difference of brokerage becomes significant, then investors don't hesitate to shift.
Also, note that switching cost does not have to be monetary. Facebook and Whatsapp are the perfect examples of the great economic moat without having any monetary switching cost. Apart from Facebook, there were dozens of social networking websites. Most of them were forced to close their operation. Competitors like Google was also forced to shut down their social networking site Orkut. It doesn't cost a penny to switch from Facebook. However, the networking effect prevents shifting. Apart from Whatsapp there are many more free mobile chat applications. All my friends are already in Whatsapp. For me, it is not convenient to switch rather I need to invite all remaining friends in Whatsapp. Such networking effect is very powerful to create a wide economic moat.
How to identify economic moat/competitive advantage?
Identifying economic moat is purely subjective. You need to analyze the supply-demand scenario, customer base, and product/service differentiating factors. There is no such specific formula to identify economic moat. However Return on Equity (ROE) offers an approximate view. Increasing ROE over the last 5-10 years with improved operating margin and cash flow is quite prominent signal of economic moat.
