Thursday, February 19, 2015

Build Yourself a Moat

Image of Baddesley Clinton from Museo8bits
The moated manor house of Baddesley Clinton in Warwickshire, England
In the ancient and medieval periods, cities and castles were often built with moats to protect them from outside enemies.  These deep trenches were built next to the outer walls and often filled with water to make it more difficult to reach and breach the walls.

The metaphor of moat building is often applied to business. In 1999, Warren Buffet pointed out that “The key to investing is . . . determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”  Those moats protect the company from excessive competition and allow them to provide above market rates of return.

In their 2014 book, Why Moats Matter, Heather Brilliant and Elizabeth Collins identify five major sources of competitive advantage or economic moat:
  • Intangible Assets include brands, patents or licenses that limit the ability of other companies to compete against you.
  • Cost advantages allow you to provide your products or services at a lower cost than your competitors.
  • Switching costs are the inconveniences or expenses a customer will incur to move from your company to a competitor. 
  • Network effects cause the value to of your products or services to expand as more people use them.
  • Efficient scale is a situation where a market has a size limitation that discourages competition.
Why Moats Matter book coverAs business people, we need to find ways to build these types of moats around our businesses.  As investors, we need to seek out and buy companies that have strong and increasing competitive moats already in place.

What type of moat are you building?

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When Your Name Becomes an Adjective
The Benefits of Going Nowhere
The IDE3A Process