SIMON BROWN: It’s really important to know your moat
You’ve heard the term: the factor that keeps companies’ competitors at bay. Sometimes this is as simple as a powerful brand, but more often it’s the cost of switching to a rival that counts
As an investor I’m always looking for a business’s moat. Something that protects it from competition — either existing rivals or new competitors which may emerge.
This may be something as simple as brand value. Think Coke vs Pepsi, or the razor trap whereby Gillette sells you a razor handle really cheaply, and then you spend the rest of your life paying for expensive razor blades from the same company.
The problem with this kind of moat is that switching to another brand or product is not actually that hard. I can drink Pepsi or Coke, and grow a beard to avoid the razor tax.
So, these are weaker moats and this leads me to discuss what could be a strong moat — switching costs.
Switching from Gillette is certainly possible and that cost to switch is not huge. Run down your razor blades to the last one and buy another brand next time or, better yet, use a safety razor at a fraction of the cost.
But some switching costs are much higher, and not always in cash. I use Google services for my business e-mail. This service was free for the past decade or more, but no longer. The switching cost keeps me in place and paying. Here the cost is not monetary — it is the effort to actually move everything and learn a new system, for which I’d be paying anyway.
The switching cost keeps me in place and paying. Here the cost is not monetary, it is the effort to actually move everything and learn a new system
But also think of this in a larger environment, and the potential impact on your investments.
A business that ships products to clients needs a logistics company to manage that delivery. Switching the entire logistics system across to a new provider could likely only be done for a large saving, not just a few cents.
This gives a moat of sorts to the logistics company and perhaps means it could raise margins a little to add more profits. Inversely, the company using the logistics firm is in some ways trapped and at the mercy of its logistics provider.
The risk is that if your logistics company starts price gouging, that switching cost becomes smaller and the economics becomes way more favourable for a switch.
The point for an investor is to understand how a business gets its new customers — and how it keeps them.
Price and quality are always great ways to win new business, and some businesses will drop margins to secure new long-term contracts because they’ll make it up over the duration of the contract.
Perhaps most important is that, ultimately, no moat is totally impenetrable, and the competition is always looking for a weakness.
This leads to perhaps the best moat: innovation. That is, completely new products or categories — just think of the iPhone. Here the costs are steep R&D, the risk that the product fails and the reality that the competition will copy your innovation (hello, Samsung).
So no moat is perfect or permanent, but while in place a moat can give an edge with increased revenue and, potentially, profit. However, always be watching the competition.
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