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205-Economic Moats
  Course 205:
  Economic Moats
  In earlier lessons of this series, we introduced the concept of an economic
  moat and the role it plays in identifying whether a business will stand the
  test of time. To define, an economic moat is a long-term competitive advantage
  that allows a company to earn oversized profits over time. Quite simply,
  companies with a wide moat will create value for themselves and their
  shareholders over the long haul, and these are the companies you should focus
  your attention on.
  
  The term "moat" in regard to finance was coined by one of our favorite
  investors of all time, Warren Buffett, who realized that companies that reward
  investors over the long term most often have a durable competitive advantage.
  Assessing that advantage involves understanding what kind of defense, or
  competitive barrier, the company has been able to build for itself in its
  industry.
  
  Moats are important from an investment perspective because any time a company
  develops a useful product or service, it isn't long before other firms try to
  capitalize on that opportunity by producing a similar--if not better--product.
  Basic economic theory says that in a perfectly competitive market, rivals will
  eventually eat up any excess profits earned by a successful business. In other
  words, competition makes it difficult for most firms to generate strong growth
  and profits over an extended period of time since any advantage is always at
  risk of imitation. The strength and sustainability of a company's economic
  moat will determine whether the firm will be able to prevent a competitor from
  taking business away or eroding its earnings.
  
  
  How to Build a Moat
  There are a number of ways a company can build a sustainable competitive
  advantage in its industry. Among the more qualitative measures commonly used
  to assess a firm's economic moat:
  
    Creating real or perceived product differentiation
    Driving costs down and being a low-cost leader
    Locking in customers by creating high switching costs
    Locking out competitors by creating high barriers to entry or high barriers
    to success
  Thankfully we've been able to whittle down all of the types of advantages in
  the marketplace. In Lesson 204, we identified the four main types of economic
  moats, and below we provide a bit more detail, using examples. The more types
  of moats a company can build, the better.
  
  
  Low-Cost Producer or Economies of Scale
  Companies that can deliver their goods or services at a low cost, typically
  from economies of scale, have a distinct competitive advantage because they
  can undercut their rivals on price. Likewise, companies with low costs can
  price their products at the same level as competitors, but make a higher
  profit while doing so.
  
  This type of moat creates a significant barrier to entry, since a
  prohibitively large amount of capital is often required to achieve a size
  needed to be competitive in a market.
  
  Dell
  Dell's DELL success is due to the company's famous build-to-order direct-sales
  business model, which eliminates expensive middlemen, lowers working-capital
  investments, and provides real-time market information to management. The
  direct model's low-overhead advantage allows Dell to undercut rivals without
  sacrificing features or profitability. The firm has consistently improved
  margins and increased revenue, in good times and bad, by replicating the model
  across several new markets. Most recently the firm has moved into consumer
  electronics, which is typically a lower-profit-margin market. But given Dell's
  low-cost structure, it may succeed here as well. Along the way, Dell's
  competitive advantage in building computers, servers, and notebooks at the
  lowest possible prices has made life extremely difficult for other
  manufacturers, particularly Gateway GTW and HP Compaq HPQ. The cyclicality of
  the IT industry carries some risks, but Dell's robust cash flow and strong
  balance sheet help mitigate those risks.
  
  Wal-Mart
  Wal-Mart WMT is perhaps the most salient example of a company benefiting from
  economies of scale, and for good reason. As a dominant player in retailing,
  the company's size provides it with enormous efficiencies that it uses to keep
  costs low. For example, its size allows Wal-Mart to do its own purchasing more
  efficiently since it has roughly 5,000 large stores worldwide. This gives the
  company tremendous bargaining power with its suppliers.
  
  Not only does it get its products cheaper, but its size allows it more
  inexpensive distribution. In addition, it has an enormous amount of
  information concerning consumer likes and dislikes, and it can spread its best
  practices across its entire store base.
  
  To see economies of scale in action, let's assume that Wal-Mart can acquire a
  DVD from a supplier for $5, while it costs one of Wal-Mart's smaller
  competitors $6. It also costs Wal-Mart $4 to distribute the DVD and pay for
  the overhead costs of the stores, while it costs the smaller competitor $5 to
  do the same. Wal-Mart can then sell the DVD for $9.50, and still make a $0.50
  profit. The smaller competitor can't charge that little, because at a cost of
  $11 per DVD, it would be losing money.
  
  
  High Switching Costs
  Switching costs are those one-time inconveniences or expenses a customer
  incurs in order to switch over from one product to another, and they can make
  for a very powerful moat. Companies that make it tough for customers to switch
  to a competitor are in a position to increase prices year after year to
  deliver hefty profits. Companies aim to create high switching costs in order
  to "lock in" customers. The more customers are locked in, the more likely a
  company can pass along added costs to them without risking customer loss to a
  competitor.
  
  Autodesk
  Autodesk ADSK dominates architecture and construction-design software with its
  market-leading AutoCAD product. With roughly 6 million loyal users, it has a
  wide economic moat--high switching costs make it tough for customers to get
  comparable products elsewhere or do their jobs without the help of Autodesk.
  Because customers are essentially required to understand its software to be
  successful in their careers, it is nearly impossible for competitors to take
  meaningful market share from Autodesk.
  
  Autodesk's software is also relatively affordable, making it somewhat immune
  when the economy turns south. While some software costs millions of dollars,
  Autodesk's products cost much less; the initial price of AutoCAD is only a few
  thousand dollars. This makes the company less susceptible to cutbacks in
  information-technology spending. In addition, using its software reduces
  expenses by shortening the design and manufacturing processes. The firm has
  also incorporated subscription sales, which add more predictability to its
  business model and further "lock in" its customers. As with many technology
  companies, uncertainty remains regarding its new product development cycle and
  adoption of new products, but Autodesk's committed customer base give the firm
  a wide economic moat.
  
  Citigroup
  If you've ever taken the time to move all of your account information from one
  bank to another, you know what a hassle it can be. Even if another bank is
  offering the same services for $1 less per month or maybe a slightly higher
  interest rate on deposits, is all the extra effort needed to switch really
  worth it?
  
  You may also want to look at your wallet and think about your credit cards.
  How long have you had some of those cards, and why do you keep them? Surely a
  better deal could be had elsewhere. But perhaps you have built up
  frequent-flier miles on your cards, have your utility bills automatically
  charged, or enjoy the familiarity that having the same account for a long time
  offers.
  
  Clearly, banks and credit card companies enjoy the benefits of the high
  switching costs their customers would incur by leaving. As the largest credit
  card issuer in the world, Citigroup C is one of the beneficiaries. It is also
  worth noting that Citigroup enjoys switching costs across a large number of
  its other financial services businesses, making for an impressive firmwide
  moat.
  
  
  The Network Effect
  The network effect occurs when the value of a particular good or service
  increases for both new and existing users as more people use that good or
  service. It can also occur when other firms design products that complement an
  existing product, thereby enhancing that product's value. The network effect
  is arguably one of the most potent competitive advantages, and it can also
  quickly catapult firms to the lead in new industries.
  
  Adobe
  Like Autodesk, Adobe ADBE actually enjoys two economic moats. The firm's
  Acrobat software has become the standard for reading and creating documents
  electronically. Because customers, such as graphic designers, are trained
  early in their careers to use products like Photoshop and Illustrator, it's
  nearly impossible for competitors to take meaningful market share. High
  switching costs make it tough for customers to get comparable products
  elsewhere or do their job without Adobe.
  
  As if switching costs weren't enough, Adobe also benefits from the network
  effect. With more than 500 million copies downloaded, Acrobat has a foothold
  on computer desktops everywhere. As its network effect increases, and more
  designers and readers use Adobe's software, its position as a standard-bearer
  grows.
  
  eBay
  When the online auction market was just getting started, eBay EBAY was the
  largest. As the site with the most sellers, it had the widest selection of
  products. This attracted the most buyers. Because it had the most buyers, it
  attracted more sellers.
  
  The cycle just continued to feed on itself, and now eBay is essentially the
  only real online auction site of size. It was able to capture this position
  even though some large, well-known, and well-financed Internet companies such
  as Yahoo YHOO and Amazon AMZN tried to make a frontal assault on eBay in the
  late 1990s with very little success.
  
  
  Intangible Assets
  This category incorporates several types of competitive advantages including
  intellectual property rights (patents, trademarks, and copyrights), government
  approvals, brand names, a unique company culture, or a geographic advantage.
  It may be difficult to assess the durability of some of these advantages, so
  be sure you have a grasp of how long this type of competitive advantage might
  last. Brand equity, for example, can be damaged or slowly erode over time,
  while government approval can be revoked. Try to understand how susceptible a
  firm might be should this kind of advantage be disrupted.
  
  Moody's
  Moody's MCO plays an important role in the capital markets by evaluating the
  risk associated with borrowers and debt instruments. The rating process is
  hardly ever easy. The federal government has created a designation--nationally
  recognized statistical rating organization--that a company must acquire before
  moving into the market. Achieving this designation is very challenging,
  meaning that the rating business is basically a government-sanctioned
  oligopoly with a limited number of competitors.
  
  The government protection Moody's enjoys is virtually priceless. Operating
  profit margins have been higher than 50% over the past couple of years, thanks
  to growth in international and structured finance, where pricing is especially
  sweet. These high margins lead to excellent cash flow from operations. The
  company requires very little in the way of capital investment, so its leverage
  is low and free cash flow is strong.
  
  Harley-Davidson
  Anytime people are willing to tattoo a company's logo onto their arms, it is a
  surefire sign of a powerful brand. The firm, the only continuous survivor from
  the original American motorcycle industry, is more than 100 years old. The
  brand built over this time has allowed Harley HDI dealers to sell motorcycles
  at or above manufacturer's suggested retail price for years. Despite selling
  essentially the same steel, chrome, and rubber as its competitors, it can
  charge premium prices for its products. And as we'll see in later lessons,
  Harley's brand has translated into solid financial results for the company.
  
  
  The Bottom Line
  While having these four types of moats, or competitive advantages, as
  guidelines is helpful, there is still a lot of art to determining whether a
  firm has a moat. At the heart of it, the harder it is for a firm's advantage
  to be imitated, the more likely it is to have a barrier to entry in its
  industry and a defensible source of profit.