Identifying companies which have an edge over their competitors which they are able to maintain is an important component of investing.

After all, it is the companies which possess these qualities which can deliver above average returns for longer than might otherwise be expected.

In this context, legendary investor Warren Buffett popularised the idea of an ‘economic moat’ which is the modern-day equivalent of a medieval moat around a castle. The term moat is interchangeable with competitive advantage.

His UK counterpart Terry Smith puts it this way: ‘If you seek to invest in companies which have above average profit margins, cash generation and growth and produce higher than average returns on capital they naturally face competitive threats.

‘How do they defend those returns from competition? What Warren Buffett calls the “moat”.’

Before discussing the various types of economic moat, we want to introduce a Buffett principle which remains central to his investment approach.

Buffett only contemplates buying a business if it is within his ‘circle of competence’. This means he understands a company’s economic characteristics and the competitive landscape.

Every investor will have their own areas of expertise, but what matters most is knowing where the boundary of that knowledge ends.

‘Know your circle of competence, and stick within it,’ insists Buffett.

Having a good understanding of the economic characteristics of a business is crucial for working out what it might be worth. This, in turn, gives investors their own edge.

A business which possesses strong economic characteristics, such as healthy operating margins and high returns on capital is worth a lot more if these characteristics are long lasting and durable.

This is the key to creating profitable growth and value for shareholders.

The durability principle also explains why Buffett prefers to own relatively stable businesses where he is more certain of their future, and steers away from industries like technology where the future is more uncertain.

Terry Smith’s take on competitive moats

Brands: strong brands attract consumers and can achieve superior pricing and returns.

Distribution: It is not enough to have strong brands. You also need to get the products to the customer through supply chain logistics and relationships with retailers and ecommerce platforms.

Installed bases of equipment and/or software: if you install elevators or testing equipment, software or processing systems then you often develop a relatively tame client base which is locked into using your equipment and systems to whom you can supply upgrades, service and spares, at a charge of course.

Network effects: some products produce powerful network effects and once a leader is established there is little incentive for consumers to shop around or use competitors. Social media is an obvious example.

Patents: a patent is legal protection against competition granted to inventors in order to encourage investment in innovation. A typical example is drugs. The problem with patents is that they expire and the patent holder then faces generic competition.

But the best companies parlay patent protection into a defensible market position. Mr Otis patented the safety elevator before the American Civil War so the patent has long expired, but Otis has the largest installed base of elevators and escalators of any company in the world to which it sells servicing, spares and modernisation.

An example of a British company with a competitive advantage in my view is Unilever (ULVR), the consumer goods business. Unilever’s brands which have over €1 billion in sales include:

Dove – personal care

Knorr – food

Hellmann’s – food

Magnum – ice cream

Rexona (also known as Sure) – deodorant

Lux and Lifebuoy – soap

It is not enough just to own brands with large sales revenues. The brands have to maintain relevance for consumers through innovation and be supported by advertising and promotion, increasingly through digital channels.

WHAT ARE THE MAIN TYPES OF A DURABLE COMPETITIVE ADVANTAGE?

When searching out competitive advantages, it is useful to bear in mind that companies can possess more than one moat, giving them multiple defences against the competition.

Most competitive advantages are intangible in nature, because something which is intangible like a brand or patent is harder to replicate than something physical like a factory.

While there are clear advantages to owning intangible assets, that does not necessarily mean that all physical assets can be replicated.

British hedge fund manager Christopher Hohn who founded The Children’s Investment Fund, was a cornerstone investor in Spain’s Aena (AENA:BME) airport group when the government sold a stake in the airport operator.

Hohn believes the investment is a good example of a high-quality infrastructure asset possessing a strong economic moat. Major cities like Madrid are unlikely to add a second airport given its size and importance, according to Hohn.

Infrastructure assets like toll roads, bridges and communication networks are essential for the smooth running of local communities, tend to have high barriers to entry and offer predictable, long-term cash flows.

SCALE BENEFITS SHARED

Scale by itself is a powerful economic moat because it provides a cost advantage through economies of scale and increased efficiencies. This enables a firm to lower prices and take market share.

Alternatively large firms can use their cost advantage to fund innovation and expansion, further strengthening their market position.

There is another type of scale advantage which was first identified by fund managers Nick Sleep and Qais Zacharia who ran the Nomad Partnership and fund between 2001 and 2014.

The Nomad Partnership delivered an exceptional track record achieving a 921% total return compared to the MSCI World index’s 117% return over the same period.

Sleep and Zacharia focussed exclusively on identifying companies with durable economic advantages that leverage the idea of ‘scale economies shared’. This means passing on scale advantages to customers in lower prices.

Their analysis showed that companies which embed this model into their core operations become stronger over time because the value proposition improves for everyone in the ecosystem, not just shareholders.

The insight is counterintuitive because it is commonplace for businesses to want to maximise a cost advantage by keeping all the gains for themselves. By passing on the savings, customers reciprocate by patronising the business more frequently.

US retailer Costco Wholesale (COST:NYSE) guarantees its customers cannot buy their goods any cheaper by passing on its bulk buying advantages. This builds customer loyalty which extends their lifetime value.

Sleep and Zacharia believe online market place Amazon (AMZN:NASDAQ) is one of the best companies operating the scale benefits shared model.

A UK example is grocer Tesco (TSCO) which takes advantage of its leading market position and bulk buying by sharing the savings with customers, in the form of lower prices. This drives customer footfall, creating a powerful flywheel effect.

A counter view: why competitive advantages can be hard to maintain

Not all fund managers see the benefits of applying Buffett’s idea of competitive moats. Portfolio manager of the JO Hambro UK Dynamic Fund, (BDZRJ10) Tom Matthews believes the idea of economic moats is potentially dangerous.

‘We don’t really like to talk about durable advantage as it can lull investors into a false sense of security and, in doing so, suggest there is no need for an observable margin of safety with the future cashflows,’ explains Mattews.

‘Increasingly, nothing lasts for ever. The life-cycle of businesses have shortened dramatically. In 1990 the average tenure of a company in the S&P 500 was 20 years and by 2021 this had fallen to just 14 years. AI will accelerate this trend further.’

Matthews and the team prefer to focus on ‘strategic transformation where management actions are unlocking capital and re-allocating to where the company can increasingly build a sustainable competitive advantage’.

What Matthews is looking for are situations where the market underestimates the sustainable trajectory of new revenue streams and cash flow.

‘A classic example of this would be Rolls Royce (RR.). Does Rolls Royce have a durable competitive advantage in Small Modular Reactors (SMRs) and data centre power?

‘Possibly. But of more interest to us as investors is that the current share price still does not reflect Rolls Royce’s growth as being sustainable.’

PRICE VERSUS VOLUME GROWTH

Pricing power is a powerful economic moat because it implies a company can raise its prices without meaningfully impacting the volume of product sold.

Often this come down to the strength of a brand, but there is another aspect of price which is just as important. Companies which grow revenue by producing more stuff have an associated cost attached.

On the other hand, companies which can increase price see 100% of that benefit drop though to profits, which makes it more powerful.

So far, we have discussed the importance of moats and how to identify different types of competitive advantage. How do investors decide how durable that advantage might be?

Eric Burns, Fund Manager at Sanford DeLand says: ‘A great test of the durability of a competitive advantage of a business is how it performs during an economic downturn. Is its product or service so special that customers still need to buy it, even when times are tough?

‘Businesses such as Unilever that own strong consumer brands tend to be resilient across the cycle, but they are not bomb-proof. One business that is, in our view, is Rightmove (RMV).

‘There is a textbook network effect at play whereby the more homes it lists on the site, the more house hunters use it to search for properties, which in turn leads to more listings.

‘It has become so ubiquitous in the property market that estate agents cannot afford to withdraw from it – even in a tough market. As a result, with the exception of the Covid period, it has grown earnings per share every year since its IPO in 2006,’ explains Burns.

PORTER’S FIVE FORCES & MICROSOFT

Porter’s Five Forces analytical framework was developed by Michael Porter in 1979 and it has become a widely accepted way to analyse a company’s place in its competitive landscape.

The model consists of five basic forces, as shown in the graphic.

Microsoft (MSFT:NASDAQ) needs no introduction. There are few other companies whose products are so embedded in clients’ everyday processes, whether it is Word, Excel, Outlook, Teams, or more advanced tools within its cloud computing platform Azure, which offers powerful analytics, secure data storage, global networking and much more.

Years of robust financial growth and huge cash flows allow Microsoft to compete with anyone in bleeding edge technology development and its large-scale investments in AI and innovation are paid for by years of robust financial performance and huge cash flows, allowing Microsoft to extend its global reach, make strategic acquisitions and continually expand its market influence and diversification. 

With the help of research by industry analysts and academic studies, Shares’ Five Forces analysis of Microsoft shows that competition is likely the company’s biggest threat, while the likelihood of rival products being developed that can compete head-on with Microsoft and the bargaining power of customers, its lowest risks.

The intensities of the Five Forces in Microsoft’s industry environment are assessed, while the box which follows shows the sub-factors that play the biggest role.

PORTERS FIVE FORCES APPLIED TO MICROSOFT

COMPETITIVE RIVALRY OR COMPETITION

Customers’ incentives to switch: WEAK

Aggressiveness of consumer electronics and IT firms: STRONG

Diversity of firms: STRONG

BARGAINING POWER OF BUYERS OR CUSTOMERS

Low substitute availability: WEAK

Customers’ incentives to switch: WEAK

High quality information on IT firms and products: STRONG

BARGAINING POWER OF SUPPLIERS

Size of suppliers: MODERATE

Population of suppliers: MODERATE

Overall supply: MODERATE

THREAT OF SUBSTITUTES OR SUBSTITUTION

Performance of substitutes: WEAK

Availability of substitutes: WEAK

Customers’ incentives to switch: WEAK

THREAT OF NEW ENTRANTS OR NEW ENTRY

Cost of IT and technology: WEAK

Cost of doing business: MODERATE

Customers’ incentives to switch: WEAK

CONCLUSIONS

Competitive rivalry or competition: STRONG

Bargaining power of buyers or customers: MODERATE

Bargaining power of suppliers: MODERATE

Threat of substitutes or substitution: WEAK

Threat of new entrants or new entry: MODERATE

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