Business quality and competitive advantages (moats)
Identify the five main sources of a lasting competitive advantage and test them with numbers such as ROIC spread, margin stability and pricing power.
What you will learn
- What a moat is and the five main sources of lasting competitive advantage
- Which numbers provide evidence for a moat and which do not
- How to test pricing power with a simple calculation
- How moats erode and which threats to monitor
Explanation
A moat (from the water ditch around a castle) is a structural advantage that protects a company's profits from competitors for many years. Without a moat, high profits attract rivals, who copy the product and cut prices until returns fall to normal levels. A good product, a famous chief executive or fast growth alone is not a moat.
Five sources of moats
| Source | How it protects profits | Typical example (generic) |
|---|---|---|
| Intangible assets | Brands, patents and licences that rivals cannot legally or easily copy | A premium consumer brand; a patented medicine |
| Switching costs | Changing supplier costs the customer time, money or risk | Business software built into daily processes |
| Network effects | Each new user makes the service more valuable for all users | A marketplace or payment network |
| Cost advantage | Scale, process or location allows lower costs than rivals | A very large low-cost retailer; a well-located quarry |
| Efficient scale | A market only supports one or two profitable players | A regional airport or pipeline |
Evidence in the numbers
A moat should be visible in the accounts over many years, not just in one good year:
- Return on invested capital (ROIC) above the cost of capital. ROIC was introduced in lesson 6. The difference between ROIC and the cost of capital is the ROIC spread; multiplied by invested capital it gives economic profit, the profit above what investors require.
- Stable gross and operating margins through a recession, not only in boom years.
- Pricing power: the ability to raise prices without losing many customers.
- Stable or rising market share and high customer retention.
Qualitative questions help: Why would a customer not switch to a cheaper rival? What would a well-funded competitor need to copy this business, and how long would it take?
How moats erode
Technology change (a new distribution channel or product), regulation, patent expiry, shifting customer habits and poor capital allocation by management can all narrow a moat. A useful habit is to describe the moat in one sentence and then list what could destroy it.
Worked example
Hypothetical example: two companies each have revenue of €1,000 m, cost of goods sold of €600 m and therefore gross profit of €400 m (gross margin 40%). Each raises prices by 5%. Cost per unit stays the same; fixed costs, taxes and fees are excluded.
- Company F (strong brand) loses 2% of volume. Revenue = 1,000 × 1.05 × 0.98 = €1,029 m. Cost of goods = 600 × 0.98 = €588 m. Gross profit = 1,029 − 588 = €441 m, an increase of 41 ÷ 400 = +10.25%.
- Company G (commodity product) loses 12% of volume. Revenue = 1,000 × 1.05 × 0.88 = €924 m. Cost of goods = 600 × 0.88 = €528 m. Gross profit = 924 − 528 = €396 m, a change of −1.0%.
The same price increase raised F's gross profit by about a tenth but slightly reduced G's. That difference is what pricing power means in money terms.
Common mistake
Practice activity
Hypothetical example: (1) Company H has invested capital of €500 m, ROIC of 18% and a cost of capital of 8%. Company J has the same invested capital, ROIC of 9% and the same cost of capital. Calculate the economic profit of each. (2) Name the most likely moat source for: (a) a stock exchange where most buyers and sellers of a product meet; (b) a payroll software provider used by thousands of firms; (c) the only cement plant within 200 km.
Show solution
(1) H: 500 × (18% − 8%) = €50 m economic profit. J: 500 × (9% − 8%) = €5 m. H creates ten times more value above investors' requirements with the same capital.
(2) (a) network effects (liquidity attracts more participants); (b) switching costs (changing payroll systems is risky and time-consuming); (c) cost advantage from location and efficient scale (cement is expensive to transport, so a distant rival cannot compete on price).
Limitations: ROIC and the cost of capital are estimates; one year of figures can be distorted by one-off items, so use a multi-year average.
Key takeaways
- A moat is a structural advantage; the five main sources are intangibles, switching costs, network effects, cost advantage and efficient scale.
- Evidence: ROIC above the cost of capital for many years, stable margins and pricing power.
- Economic profit = invested capital × (ROIC − cost of capital).
- Always list the threats that could erode the moat.
Next step
Moats and numbers change over time; the next lesson explains the corporate events that bring new information, from earnings reports to buybacks and capital increases.
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