I realised not too long ago that to identify companies that do well in the long run, we have to look at whether their current advantage is sustainable.
With the influx of so many china counters in the singapore stock exchange, it is easy to know that many of them will not do well 5 years down the road. After all a listing is an avenue for them to unwind their positions as well. Normally IPOs happen because the management thinks they can get the most value during the placement.
Identifying long term advantages and leverage is difficult. This is because companies that used to have competitive advantages ceases to do that. Newspaper publishing used to be very lucrative. They have an advantage in the different states that they published in. Think SPH. It is the defactor news publisher and some say it is the political publication for the incubent party(dun quote me on this, i dun want a lawsuit.)
With such an advantage in business, it is difficult for competitors to come in.
Here Fat Pitch Financials lists some of the Economic Moats that will enable companies to remain competitive. Having these economic moats enables the business to have sustainable and increasing margins, which is an important factor you should look at when identifying a good business.
- Low cost leader – The product attribute many customers look at is price. Developing a lean an efficient operation allows you the room to survive price wars. Large operations often leverage economies of scale to become the low cost leader.
- Brand name franchise – Developing a great brand can be a long and involved process to develop customer trust and mind share. Creating a brand is not enough to gain a wide moat. You need to be able to convert that brand into a franchise that customers connect with at many levels. A brand that can be converted into a franchise can then be expanded into other related products and services and keep competition from nibbling away at your corners.
- Trademarks - A distinctive design protected by law that you can use to develop an instantly recognizable mark that can instill a positive emotional response in your customers. Trademarks alone rarely create moats but they can be very powerful when combined with a brand name franchise. Think the Nike swoosh or the Ralph Lauren Polo Logo that automatically command a price premium from almost any product they are placed on.
- – Maintaining exclusive rights to either your writing or someone else’s unique work can produce a long term profits. Publishers that own the copyrights of famous books and owners of the copyrights of enduring songs, such as “Happy Birthday to You” have sustainable competitive advantages and can continue to collect hansom profits for years under long lived copyright laws. It makes you think twice before adding that open source or Creative Commons license on your work.
- Patents – A government grant of exclusive rights (think legal monopoly) granted in exchange for publicly disclosing the details of an invention. Patents are the power behind Big Pharma, GE, and many technology companies.
- Trade secrets – Trade secrets are the even wider moat version of patents. These are undisclosed secrets associated with the creation of product, a manufacturing process or a delivery of a service that are not easily replicated (rare now a days). The biggest trade secret I know of is Coca Cola’s secret formula, which was stolen recently and almost given to their biggest competitor Pepsi Co.
- Government protection – Government protections can take on all sorts of forms, but licenses, permits, exclusive contracts, and financial backing can all establish a wide moat. Individuals get professional licenses that restrict the number of people entering a profession, such as lawyers, doctors and accountants. Companies such as Sallie Mae, Fannie Mae and Freddie Mac had the financial backing of the federal government. Companies without those financial backings had serious competitive advantages.
- High switching costs – If you can produce a high value business that customers depend on and work very closely with you, it can be very hard for those customers to switch over to competitors and thus can give you a wide moat. Company’s such as ADP that handle outsourced payroll and human resource functions can be very difficult to leave after using their services for a few years. Even simpler things like email addresses used for business can make your very dependent on the email service provider if they own your email address.
- Network effect – This is one of the most powerful and unique methods of building a wide moat. The network effect wide moat is established when you create a business where the more people use your service, the more valuable that service becomes for other customers. A good modern example of this is eBay. The more buyers and sellers appear on eBay the more useful eBay becomes for other buyers and sellers by giving buyers and sellers a greater chance of making a match. Cell phone provides that offer free in network calling also make it so their network becomes more valuable to customers as more people join it because it increases their their chance of being able to make free calls. Verizon Wireless has created a network effect for my extended family.
- Toll bridges – Toll bridges are the epitome of wide moat enterprises. A toll booth on a bridge like the Delaware Bridge can command huge premiums in tolls for all who pass. The key to building a toll bridge is to identify choke points in commerce and then claim ownership over them. Because of the monopoly power that this powerful economic moat can convey, most toll bridges are run by governments. (However, many governments have started to sell off their toll roads and bridges to private companies.) Another good example of a toll bridge type moat is ownership of a key downtown parking lot. All must pay to visit by car. If space is limited, competition can be virtually non existent.