Course 204: Start Thinking Like an Analyst
Types of Economic Moats
In this course
1 Introduction
2 Four Basic Questions
3 Finding a Framework: Moats
4 What Is an Economic Moat?
5 Types of Economic Moats
6 The Bottom Line

After researching hundreds of companies, we've identified four main types of economic moats.

Low-Cost Producer. Companies that can deliver their goods or services at a low cost, typically due to economies of scale, have a distinct competitive advantage because they can undercut their rivals on price.

Wal-Mart (WMT)is a great example of a low-cost producer, and its low costs allow it to price its products the most attractively. As a dominant player in retailing, the company's size provides it with enormous scale efficiencies, or operating leverage, that it uses to keep costs low. Scale allows Wal-Mart to do its own purchasing more efficiently since it has roughly 5,000 large stores worldwide, and it gives the company tremendous bargaining power with its suppliers. Since the company positions itself as a low-cost retailer, it wants to ensure it gives the lowest prices to its customers. This can translate into tough bargaining terms for those firms that want to sell their products on Wal-Mart's shelves. As a result, Wal-Mart is able to offer prices that competitors have a difficult time matching--one reason why you don't see too many Kmarts around anymore.

High Switching Costs. Switching costs are those one-time inconveniences or expenses a customer incurs in order to switch over from one product to another. If you've ever taken the time to move all of your account information from one bank to another, you know what a hassle it can be--so there would have to be a really good reason, like a package deal on an account and mortgage for example, for you to consider switching again.

Companies aim to create high switching costs in order to "lock in" customers. The more customers are locked in, the more likely a company can pass along added costs to them without risking customer loss to a competitor.

Surgeons encounter these switching costs when they train to do procedures using specific medical devices, such as the artificial joint products from medical-device companies Zimmer (ZMH) or Stryker (SYK). After training to learn to use a specific product, switching to another would require the surgeon to forgo comfort and familiarity--and what patient, much less surgeon, would want that? Additionally, because the surgeon would have to be trained to use a new, competing product, he or she would also have to contend with lost time and money resulting from not performing as many surgical procedures. Clearly, with certain products and services, the switching costs can be quite high.

The Network Effect. The network effect is one of the most powerful competitive advantages, and it is also one of the easiest to spot. The network effect occurs when the value of a particular good or service increases for both new and existing users as more people use that good or service.

For example, the fact that there are literally millions of people using eBay makes the company's service incredibly valuable and all but impossible for another company to duplicate. For anyone wanting to sell something online via an auction, eBay (EBAY) provides the most potential buyers and is the most attractive. Meanwhile, for buyers, eBay has the widest selection. This advantage feeds on itself, and eBay's strength only increases as more users sign on.

Intangible Assets. Some companies have an advantage over competitors because of unique nonphysical, or "intangible," assets. Intangibles are things such as intellectual property rights (patents, trademarks, and copyrights), government approvals, brand names, a unique company culture, or a geographic advantage.

In some cases, whole industries derive huge benefits from intangible assets. Consumer-products manufacturers are one example. They build profits on the power of brands to distinguish their products. Well-known PepsiCo (PEP)is a leader in salty snacks and sports drinks, and the firm boasts a lineup of strong brands, innovative products, and an impressive distribution network. The company's investment in advertising and marketing distinguishes its products on store shelves and allows PepsiCo to command premium prices. Consumers will pay more for a bag of Frito-Lay chips than for a bag of generic chips. As the value of a brand increases, the manufacturer is also often able to be more demanding in its distribution relationships. To a large degree, brand power creates demand for those chips and secures their placement on store shelves.

One final thought about economic moats: It is possible for some companies to have more than one type of moat. For example, many companies that use the network effect also benefit from economies of scale, because these companies tend to grow so large that they dwarf smaller competitors. In general, the more types of economic moat a company has--and the wider those moats are--the better.

Next: The Bottom Line >>

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