Sunday, December 21, 2008

What kind of moat does your business have?

It is good to re-visit basics from time to time. One such fundamental concept I like to ponder upon is that of “economic moat” which Warren Buffett popularized. To characterize a good business Warren says:

In business, I look for economic castles protected by unbreachable ‘moats’.

Having visited a number of forts in the last couple of years, I am beginning to appreciate the concept of moat. Moats are interesting to me for two reasons: (1) I run a business myself and I definitely would like my business to have a moat and grow it wider over time; and (2) As a consultant, I assist my customers strengthen their moat. It helps to understand what kind of moat a business can have and where I can make a difference.

Morningstar gives a good introduction to economic moats. I also liked the interview of Pat Dorsey, Director, Equity Research at Morningstar on economic moats. They classify moats into 4 categories:

1. Intangible assets: These are assets an organization has that are hard to replicate. The most widely recognized intangible asset is company’s brand. A typical test used to test strength of a brand is its ability to ride inflation. Ask yourself the question: Will I continue to buy the product or service if the price goes up? Think of your favorite doctor or your favorite cigarette brand. Another type of intangible asset is Intellectual Property Rights (IPR). Many pharma companies differentiate based on IPRs. Another intangible asset is regulatory protection.

2. Cost advantage: Whole of offshoring in India is based on this type of moat. However, one needs to see where the cost advantage comes from. As Pat says, a process based cost advantage is relatively easily replicated. Southwest Airlines and Dell were icons of low-cost business model innovation once upon a time. Competition has since caught up and they are re-inventing themselves. A cost advantage due to economies of scale is more enduring. Think Wal-Mart.

3. High switching costs: It is ok for a techie to use Windows and Linux interchangeably. However, I know what a nightmare it would be to convince my parents to switch from Windows to Linux. For most people it won’t be worth the effort. There lies Microsoft’s moat. Apparently bank accounts are sticky in a similar way. Although a savings account does not differ much from bank to bank, people don’t like to switch.

4. Network effect: You create a network effect when a whole industry gets built around your product. eBay is a classic example where its attractiveness improves as it gains more buyers and sellers. Lego has created similar effect by producing modular bricks which can be used interchangeably. A visa card or American Express has the same effect.

I am visiting a marine fort Sindhudurg (100km north of Goa) this week. Perhaps I will see moat from a newer perspective.

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