After going through helpful frameworks to better understand economic moat during his fourth lecture at Peking University's Fall 2020 Value Investing Course, Chang Jing further elaborated on a few important points regarding the topic.
There are many elements embedded in the economic moat concept. Each business is different and each industry is different, so in practice, we have to consider many factors affecting the economic moat of each business.
Monopoly, oligopoly and free market
This is one of the most discussed aspects of economic moat. Monopoly is a very strong economic moat, but very few businesses have either legalized monopoly power or de-facto monopoly power.
Monopoly power can come from natural resources, government regulation, technology and sometimes consumer share of mind. For instance, WeChat is a monopoly product because it has become an indispensable part of more than one billion Chinese people's lives. This indispensability gives WeChat enormous pricing power for the services it offers to consumers.
Two common sources of monopoly are resources advantages and cost advantages, but how long can these two advantages last? In the case of cost advantage, how is the cost advantage built? These are all important questions to consider.
Oligopoly is more common than monopoly, in which a few players dominate the market. For instance, many industrial products are oligopoly markets. In the fiber glass market, the top six players have more than 70% of the global market share. But even with such a high concentration level, no player has pricing power, not even the biggest player.
Free market means there's perfect competition within the industry. For instance, the retail sector is full of perfectly competitive markets such as clothing, restaurants and convenience stores. But even if they are operating in a perfectly competitive environment, some business can establish strong economic moat in certain niche markets.
Comparative advantage versus competitive advantage
There's a simple theory in economics about the lawyer and the secretary. A lawyer can be a very good secretary, but only by being a lawyer can they maximize their value.
This is the point of specialization and trade. Many businesses possess comparative advantages, sometimes due to unique situations or the country they operate in. For instance, the Chinese textile industry had enjoyed comparative advantages against non-Chinese competitors due to cheap labor rates. However, now Indian and Southeast Asian companies have gained comparative advantages because their labor forces are cheaper than Chinese competitors. We have to consider the sustainability of comparative advantages.
Competitive advantages, on the other hand, are more systematic. Whereas comparative advantages often result from cost advantages, competitive advantages can arise from many sources such as innovation, brand, management, etc. Investors should not only differentiate between comparative advantages and competitive advantages but assess the sustainability of both.
First-mover advantage versus late-mover advantage
In some industries, first-mover advantage is very important and sustainable. In some markets, late-mover advantage is sustainable. For instance, for any industries in which technology changes very fast, late-movers often have some advantage, though it may not be sustainable if the technology keeps changing. In search and social networking, the first-mover advantage is very clear and powerful due to accumulation of data, share of mind, etc.
Focus versus diversification, niche/specialization versus general
Whether to focus on a niche market or to diversify into different businesses can be the result of strategic choice by management or the natural result of competitive dynamics. There are many hidden champions in the world. Focus is key to their success, but diversification itself isn't necessarily bad.
For instance, Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) has become a huge conglomerate with many diversified businesses across many industries. But to some extent, each newly acquired business adds to Berkshire's economic moat. Again, each industry is different. Each business is different.
Intangible assets
The business world today is increasingly driven by intangible assets such as intellectual property and brands. However, the value of the intangible assets is often misrepresented on the balances sheet. This has been a huge challenge for value investors who rely on the balance sheet to gauge whether a business is undervalued or not.
Companies that invest heavily in intangible assets such as intellectual property, employee training and culture-building have less tangible assets on the balance sheet. However, it is precisely the unrecorded and important intangible assets, which Warren Buffett (Trades, Portfolio) calls economic goodwill, that make them so profitable and valuable. For a better understanding of economic goodwill, Chang recommends reading Buffett's 1983 letter to shareholders.
Economic moat in the internet era
The traditional framework of evaluating economic moat needs to embrace new elements to adapt to the internet era. With the internet companies, Chang mentioned that there are four common sources of economic moat we should think about – network effect, switching cost, platform advantages and ecosystem advantages. They are somewhat interconnected. For instance, in the case of WeChat, network effect, switching cost, platform advantages and ecosystem advantages all reinforce each other. It is a very powerful economic moat.
Read more here:
- Notes From Peking University's Fall 2020 Value Investing Course - Lecture 4, Part 2
- Notes From Peking University's Fall 2020 Value Investing Course - Lecture 4: Economic Moat​
- Notes From Peking University's Fall 2020 Value Investing Course - Kweichou Maotai Case Study
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