A Look at Economic Moats - Part 2

By Chris Gallant | November 23, 2005 AAA

While there are many types of economic moats (competitive advantages), those of particular interest to the Investopedia Advisor team are those that are wide (difficult for competing firms to penetrate), of significant economic value and sustainable. Below we'll explore some of the ways a company can establish an economic moat.

First, as exemplified by Wal-Mart's (WMT) prolonged success, a cost advantage which competitors cannot replicate can be a very effective economic moat.

Companies with significant cost advantages can undercut the prices of any competitor who attempts to move into their industry, either forcing the competitor to leave the industry or at least slow or stop their growth.

Companies with sustainable cost advantages can maintain a very large market share of their industry by squeezing out any new competitors who try to move in.

Moreover, being big can sometimes in itself lead to an economic moat. At a certain size a firm achieves economies of scale (when more units of a good or service can be produced on a larger scale, yet with (on average) less input costs) which reduces overhead costs in areas such as financing, advertising, production, etc.

For this reason, large companies which compete in a given industry tend to dominate the core market share of that industry, while smaller players are forced to either leave the industry or occupy smaller "niche" roles. Two good examples are Microsoft (MSFT) and Wal-Mart.

Bigger does not always mean better but at times being the big fish in the pond does have its advantages (for more on this see The Law Of Large Numbers).

Related to economies of scale is when a company is able to establish itself in an industry to the point where suppliers and customers can be subject to high switching costs should they choose to do business with a new competitor. Because of these cumbersome switching costs, competitors have a very difficult time taking market share away from the industry leader.

One example here of a switching cost would be changing your cable or satellite provider. Whether it be Comcast (CMSCA), DirecTV (DTV) or EchoStar Communications (DISH) providing your service, once you have that company's system in place, the switching costs can be a big deterrent to changing providers.

An even better example of an instance where high switching costs have led to an economic moat comes from a Core Holdings selection we made at the Investopedia Advisor back in July – Iron Mountain (IRM). Iron Mountain is a company that stores documents for businesses and renews an astonishing (nearly 99%) percentage of its clients every year. Iron Mountain has developed a wide and sustainable economic moat partially based on high switching costs their customers face. (Since adding IRM to our Core Holdings portfolio the stock has shot up nearly 45%).

Get this - Iron Mountain lost 600,000 copies of Time Warner's (TWX) employee records a few months back. After such a fumble you would think that Time Warner would head for greener pastures and move their business elsewhere. Not the case. In fact, following the incident a Time Warner spokesperson commented that Iron Mountain had an "excellent track record" and would not be moving their business!

Iron Mountain's success is not solely based on their high switching costs - they have made smart acquisitions and have used leverage to their advantage - but it's a big part. After Iron Mountain has a firm's documents in storage, it's a huge pain to physically move them to another location.

Another type of economic moat can be created by a firm's so-called intangible assets, which includes items such as patents, brand recognition, government licenses and others. Strong brand name recognition, enjoyed by companies like Coca-Cola (KO), McDonald's (MCD) and Nike (NKE), allows these types of companies to charge a premium for their products over competitor's goods, boosting their profits.

For another example, consider drug companies like Pfizer (PFE), Merck (MRK), GlaxoSmithKline (GSK) or Novartis (NVS) and the intellectual patents on specific drugs they hold. Their rights to specific pharmaceutical products can effectively bar all competition from successful drugs for the duration of the patent, allowing the company guaranteed long term profits and market share. Once the patents run out however they are susceptible to competition from generic drug manufacturers.

Furthermore, simple cooperation resulting in what is called the network effect can also provide a company with a significant economic moat. A good example of this is the success of eBay (EBAY). One of the major contributors of eBay's success is their popularity amongst small online merchants and other service providers, who began to create businesses built upon eBay's auction service.

This added value for the millions of auction participants who visit eBay and has resulted in an business network which competing auction websites have been unable to breach.

Finally, some of the reasons a company might have an economic moat are more difficult to identify. For example "soft moats", may be created by exceptional management or a unique corporate culture. While difficult to describe, a unique leadership and corporate environment, such as that of Southwest Airlines (LUV), can be at least partially contribute to a corporation's prolonged economic success, even while operating in a historically less than robust industry (for more on this see Warren Buffett, Airlines and 800 Numbers).

Another example of this unique corporate culture transferring to the bottom line might be the story of Google (GOOG), whose unique corporate culture has no doubt contributed to the company's success.

The prolonged success of General Electric (GE) under the unique leadership of Jack Welch during the 1980s and 90s also provides us an example of a "soft" economic moat. While there is no consensus on the exact value GE's former CEO added to the company, it is difficult to argue against the positive effects of Welch's leadership.

Like many things in the world of finance, economic moats are generally difficult to pinpoint at the time they are being created. Their effects are much more easily observed in hindsight, once a company has risen to great heights. Indeed, many of the retail outlets that were decimated by Wal-Mart's historic growth in size admittedly did not see the threat coming until it was much too late.

From an investor's point of view, it is ideal to invest in growing companies just as they begin to reap the benefits of a wide and sustainable economic moat, the most important factor being the longevity of the moat. The longer a company can harvest profits, the greater the benefits for itself and its shareholders!

Looking to cook up a market-stomping stock portfolio? Check out our FREE report "7 Ingredients to Market Beating Stocks" and get started right now!

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