Moats are hallmarks of quality businesses. A company that can differentiate itself from the competition, either with a great product, unique intellectual property, a loyal customer base or a combination of these factors, is set up for long-term success. Warren Buffett (Trades, Portfolio) in particular has been a vocal proponent of the idea that moats are a key component of value. Why do moats matter and does your company have one? Let’s explore some of the different types of moats to help answer these questions.
Product quality
One of the most common sources of a moat is a high-quality product that is hard to replicate, either due to a complex manufacturing process or copyright protection. Apple Inc.’s (AAPL, Financial) iPhone is an example of both - it is relatively difficult to build and also benefits from a complex system of patents that ensure a competitor cannot produce a carbon copy of the device.
In cases where the business in question provides a service, a moat can take the form of exceptional customer service. Perhaps it is a medical company specializing in the operation of assisted living facilities for seniors, which is known for having particularly well-trained staff. Although these kinds of moats are typically narrower and harder to define, they can be significant if the business has a sophisticated structure that is hard to mimic.
The benefit of size
In some cases, simply being the biggest can be a moat in and of itself. Companies with large research and development departments and huge sums in their corporate treasuries are typically much more robust than smaller competitors who concentrate on a narrower range of products and services. Large companies also benefit from economies of scale, resulting in a decrease in the per-unit cost of manufacturing. This allows them to charge lower prices to their consumers, which competitors have trouble matching.
Additionally, large and established businesses have existing relationships with their industry suppliers, meaning these suppliers will not deal with newer companies in the space. This further drives up costs for disruptors.
Furthermore, large companies often lobby governments for preferential treatment, which makes it hard for startups to enter their industry. Leaving aside the question of whether this is right or moral, having the government's support is a huge boon for a company. Boeing (BA, Financial) and Airbus (XPAR:AIR, Financial) dominate the global market for commercial aircraft partly because of the support afforded to them by the U.S. and European Union.
ConclusionÂ
While it is easy to say every sector can be disrupted by brash, young newcomers, the reality is that more often than not, larger companies outlive their challengers. Size confers the ability to lower costs and create favorable regulatory conditions. It also means more cash with which to refine product design and to finance expensive research and development budgets. After all, industry giants are giants for a reason.
Disclosure: The author owns no stocks mentioned.
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