⚠️ This is one of my longer blogs to help break down competitive advantage. Grab a coffee and buckle up.

A competitive advantage, which is also known as an economic MOAT, is a distinguishing characteristic or feature of a business that enables it to generate profits above the average and prevent competitors from significantly affecting its profit margins. It allows a company to continue earning excess returns on capital over a longer period of time while fending off competition.

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What is a Competitive Advantage?

A competitive advantage is a crucial investing term that every investor should understand. When a company can protect its profit margins and excess returns on capital for a sustained period, it can be a great compounder.

Having a strong and durable advantage enables a company to keep growing and reinvesting in itself without worrying about competitors eating away at its profits. This advantage is also known as an Economic MOAT, which is a structural business characteristic that allows a business to earn higher returns.

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

Warren Buffett

If a business can protect itself from competitors and has a long runway of growth with plenty of reinvestment opportunities, it can compound capital at far greater rates than if its margin or market share were under threat.

Companies that gain market share over time often focus on protecting their “Cash Cow” from new entrants and other outside threats. The competitive advantage can also be understood as the factors that allow a business to produce more affordable or higher quality services or products than its competitors.

An example of competitors eating away profits.

Think of it like this. You start a coffee shop, and you are the first one on the street. You enjoyed loyal customers, high-priced margins and all the profits from being the sole coffee operator.

Someone sees that business is booming and they think they have what it takes to also run a coffee shop. They start a coffee shop across the road. They start competing for your customers, both businesses do well but not as great as one by itself. Then another coffee shop pops up.

They price their coffee cheaper, with a muffin special. Now they start taking more and more clients. Now you must lower prices to attract the clients as there are more “options” for them.

If you have no competitive advantage, what was once a lucrative idea, becomes a race to the bottom for price and customers. The profits in the coffee shop across all 3 start to dwindle. This is business, a free market, where new entrants can come in and eat away the entire industry’s profits.

In short, there are numerous ways a business can develop a competitive advantage. Perhaps when you started you developed an amazing brand, and customer loyalty with rewards, secured a food license and became the only “drive-through” coffee shop allowed to open. You start building a competitive advantage a compelling reason why customers would come back to you time and time again over the other coffee shops.

Where did the term “MOAT” come from?

Warren Buffett first coined the term “MOAT” as one of his investment criteria. He invests in companies with strong durable economic MOATs that protect a company’s profits and returns from outsiders. The term was later popularised by Morningstar and Pat Dorsey who created the terms Wide Moat, Narrow Moat, and No Moat.

The idea behind a MOAT is that a wide moat stock should be able to generate a Return-on-Invested-Capital greater than its Weighted-Average-Cost-Capital for decades.

A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital.

Warren Buffett

The MOAT is a fantastic illustration of the idea of Competitive Advantage. The definition of a Moat is a deep, wide ditch surrounding a castle, fort, or town, typically filled with water, and intended as a defence against attack.

That is what all companies should strive for. A company spends capital growing, developing products and services, and reaching customers. If the business does all the challenging work, wouldn’t it want to defend its efforts and profits from outside threats?

The moat is a defensive mechanism that makes it challenging for new entrants to try and compete with them. This in turn protects their business from any material risk to the company’s long-term viability. Allowing it to continue to dominate.

The main sources of a competitive advantage and economic MOAT?

Apart from the various characteristics of a competitive advantage that we will go through, I believe two core drivers allow a company to have a MOAT.

1) To have a competitive advantage the business must provide a distinguishing benefit to its Target Market. It must be better than the competition. This is usually client-centric.

OR

2) It must have structural advantages that make it too hard to compete with. This is not necessarily client-centric. Some MOAT companies are not the greatest option for clients, it is the only option. I call them “Cartel Operators”.

Below we will dive into a list of competitive forces that can create a MOAT within an organisation. There are other competitive advantages as the landscape is forever changing due to innovation, disruption and technological advancement.

However, I have found these to be very well articulated. As an entrepreneur who has scaled competitively advantaged companies, I’d opt to build a start-up that poses some sort of durable moat from the list below.

Switching Costs

Switching costs refer to the challenges of “switching” from one product to another. The associated costs outweigh any benefit of the change. Making it hard for customers to give up a product or a service and switch to a new one means higher retention. A company can raise its prices while keeping customers. Companies that are mission-critical such as SaaS businesses have a competitive advantage of “switching cost”. Think about changing accounting software for an entire organisation.

Or perhaps changing phones from Apple (need an entirely new set-up). The idea behind this MOAT is a business can annually continue to increase prices, outpacing inflation and passing on costs to its customer base. Any benefit or cost saving would be eroded due to the complications of moving across. This could be a financial strain or just simply a headache migrating to a new product or service.

Intangible Assets

Intangible Assets can come in the form of brands, proprietary technology, patents, and trademarks. Think of pharmaceutical companies who own the patents to a drug, they can charge what they like and keep the competition away. Anything that makes a product or service unique, special, or memorable. This can also stem beyond the usual areas and into databases. That is an intangible. Think of a business that has a huge database or subscriber list.

When we think of branding, we can think about products that we don’t mind paying more for. We know the brand, there is familiarity and trust. If the brand increases prices we don’t mind paying for it. Trademarks and copyrights are great intangibles, keeping competition away from phrases, industries, names, designs, and even colours.

Network Effects

Network effects are a very powerful form of competitive advantage. The value of a product and service increases as more users, customers, and sellers join the platform. The more users the greater benefit for everyone. The obvious is social media or online e-commerce giants. For every new user, more value is created whether it is in more features, better accessibility, or greater product ranges. This is great for the bottom line. The per unit customer acquisition cost or marketing expenses can decline the more users grow.

Think about a real estate listing website. More properties bring more buyers, which attracts more real estate agents which attracts more buyers. The value is split across all users. Sellers sell their homes faster, buyers have more options and choices, and agents can list with confidence and less running around. The network effect usually benefits everyone who uses the product or service.

Cost Advantage

A cost advantage is a supply-side competitive advantage. This can also be referred to as “cost leadership”. Providing reasonable value at lower prices. Businesses that continuously improve operational efficiency benefit from this MOAT. The cost of production declines as a company continues to scale. This is about economies of scale. This can also come in cyclical businesses such as mining, that go through a cycle that leans in their favour.

The moat protects a business because it becomes a question of how hard it would be to replicate the business model. How much capital would be needed to compete? What infrastructure, IP, networks, contracts, and supply chain would be needed to try and go toe to toe? Think about trying to compete with Amazon. The cost to do this, the amount of work to set up new warehouses, fulfilment systems, digital infrastructure, and secure thousands of sellers. Forget about it.

Efficient Scale

Efficient scale usually coincides with cost advantages. This competitive advantage is about a business that has carved out a huge market share. It’s the best in the industry. This does not necessarily mean the biggest company by market cap. It could be a business in a niche that is too challenging to compete with. Often a boring industry that is overlooked.

It could be costly for a company to enter and at the same time, there may not be enough profit in the industry for a handful of players. This means profits erode faster and no one makes money. This isn’t attractive for companies to take on the risk and outlay capital for a short-lived venture. This is an industry with natural a monopoly. The industry may only support a small number of companies.

Speed and Innovation

These two are an often-overlooked competitive advantage. This could be a company developing, manufacturing, delivering, or bringing products to the market faster. It could be faster customer service and response times. Nimble companies can respond rapidly to market changes.

Mix this with innovation and this becomes a very strong MOAT. Developing better products and services, mixed with speed can help companies stay ahead of the competition. Bringing products to the market faster and having the first-mover advantage can be huge.

Why is a Competitive Advantage important in investing?

Capitalism is driven by competition. In a free market, capital flows towards the areas that offer the highest expected returns. Entrepreneurs and investors flock to attractive industries, sectors, and emerging trends.

When companies in an industry begin to perform well with high-profit margins, strong returns on capital, and significant free cash flow, it attracts competition. Unfortunately, competition can work against shareholder value, as it may erode the long-term value and attractive prospects that lead investors to the company in the first place.

All companies at some stage are vulnerable to disruption to some extent. That is why finding a company with a MOAT that has lasted decades is worthy of studying.

Companies can still provide excellent returns to shareholders without a MOAT, often over shorter holding periods. However, if you are looking for long-term compounders, a competitive advantage becomes a must.

It’s simple, if you find a compounding machine, wouldn’t you want it to compound for decades without the threat of disrupting it?

Investors seek competitive advantages because they want to compound at higher rates of return for years. If a company is well-protected and has favourable economics and a durable moat, it can achieve that goal. But if it does not, competition will eat away at those returns and diminish the returns and profit lifespan of the franchise.

The more entrants and competition there are, the less profit and returns there are because the industry becomes “competed away.” Very few companies have an economic moat, and though they may enjoy outsized returns on capital and profit margins for a short while, it usually comes to an end.

How to Identify a Competitive Advantage?

Finding companies with a sustainable competitive advantage, also known as a “moat”, is crucial for successful investing. However, there is no one formula to identify such companies. As one of the great investors has said, it takes a lot of effort to determine whether a company has a moat, how strong it is, and how long it will last.

No formula in finance tells you that the moat is 28 feet wide and 16 feet deep. That’s what drives the academics crazy. They can compute standard deviations and betas, but they can’t understand moats.

Warren Buffett

This is why it’s essential to consider a company’s competitive advantage when researching potential investments. Even if you’re not specifically looking for companies with moats, understanding whether a business will survive and thrive is vital to your investment strategy.

Short-term traders may not be as concerned with this factor, as they don’t typically hold stocks long enough to see the impact of a company’s competitive advantage.

To identify companies with moats, it’s important to start by understanding the business itself. It’s also helpful to follow a few thought-provoking steps that can guide your research.

Go to the Industries with the best chances of having a MOAT.

Certain industries are just structurally more advantageous to build a competitive edge in. So, it makes sense to go where they are. Certain sectors just do not have favourable unit economics to build a moat in. Real estate development for example. The premise is the higher ROIC over WACC. If the cost of capital is high and a company cannot reinvest Free Cash Flow at higher rates of return, then it is not attractive to competitors. The first stage of the investment process is to understand industries, which ones provide better MOATS, such as healthcare and SaaS and not low MOAT industries like Real Estate, materials, and utilities.

Find where the profits flow within that Industry.

The next step in investing is to determine where the profits flow within an industry, also known as Value Chain investing. Knowing where the profits flow downstream is crucial. Usually, companies that are likely to have a competitive advantage or MOAT are those that earn high profits within an industry. For example, the airline industry is not a great investment. However, within the air travel sector, there are online travel agents and some catering companies that earn a lot of profits. Rather than aircraft builders, some other companies further down the value chain, such as those that supply engine materials, may be more profitable with efficient scale. Find where the profit flows to get closer to durable companies.

Understand the Metrics that reflect MOAT companies.

Understanding the Weighted Average Cost of Capital (WACC) of a business and the Return on Capital (ROC) form the foundation of MOAT hunting. The aim is to find companies that can generate high returns on capital above their cost of capital for extended periods.

Companies that outperform industry standards and have better fundamentals than their peers are a great starting point. If a business has a better margin and return than its competitors, then it is likely doing something differently.

The presence of an economic MOAT is evident in the unit economics of the business. Consistency and sustainability are key factors to consider. Consistency in profit margins, high returns on capital, free cash flow, and operational performance for a minimum of 10 years are important indicators of a competitive advantage.

If a company meets any of these criteria for several years, it is worth investigating how it has sustained its performance. This is usually a sign of a competitive advantage.

Unit Economics that I look for when hunting for a MOAT:

I want to see a business that has a higher ROIC than WACC and I want to see positive, growth and a lot of Free Cash Flow. This indicates the operational efficiency of the company in converting revenue into cash.

• Free Cash Flow Yield >10% = Indicates cash left for reinvesting.
• Gross Margin > 50% High profitability.
• FCF ÷ Sales/Revenue > 10% = Converting Cash from Sales.
• FCF ÷ Earnings (Net Income) >80% = Shows efficiency (Low Operating costs).
• ROC or ROE > 20% = High returns on capital.
• Revenue Growth YoY >5% = Shows it can still grow organically.
• Earnings Growth YoY >7% = Reflects the business operational improvements.
• Net Debt ÷ FCF >5 (Pay off debt x5 over) = Low debt, allocating FCF diligently.

These are just some of the qualities I look for. This may bring up all sorts of companies on a screen. However, if you look for companies that for 5 years or 10 years have produced these sorts of metrics, there is a high possibility it has a competitive advantage. Consistency and not lumpy figures are key.

Find the MOAT of the franchise.

Once you have found companies that have the qualities of a competitive advantage it’s important to try and find out what it is. It is not just about finding companies with the right metrics and favourable economics and that’s it. Can it last? That is the question.

There must be a unique differentiation as to why it can do better than its peers and over a longer timeframe. Investors need to look in the places where value is created. The WHAT makes this company special, and different will explain HOW it will defend off competitors.

It’s time to ask questions, dig deep, and research the business model and the unit economics. Where is the company different? Does it have higher switching costs? Is there a patent or trademark? Does the company have pricing power? Does it produce a faster, lower-cost product? Is there a Monopoly? Is there a high barrier to entry?

If you do your homework the chances are you will find the reason why this company can do better than its peers and the reason why its been able to protect itself from threats.

Stress Test the MOAT after finding it.

The next step is to determine how strong the MOAT is, and how wide or narrow it is. Some companies have a MOAT but as investors, we want to understand how long it can last. Will the company be profitable and spit Free Cash Flow for a year? 5 years? 10 years? 20 years? Whilst this is not an exact science, we need to stress test how this company could be disrupted.

What are the chances of a new entrant? What would it take to disrupt this business model? Where could this company lose market share? There are a lot of questions to go through. The main ideology behind this is to determine the size of the MOAT so you can determine how long your capital can compound.

If you think the competitive edge is short-lived then are you prepared for only a shorter compounding period? I always look at market share, look at the total addressable market. See how many users, and clients, there are. Are they losing market share? Is the profit margin slowly going away? Perhaps the Free Cash Flow conversion from earnings starts to shrink. The numbers will tell you if a company is becoming inefficient. Declining numbers can be a sign the MOAT is shrinking, the company no longer can command higher prices or convert revenue to cash.

The goal for an investor is to determine whether this company can continue its higher returns.

Investing in companies with an Economic MOAT.

Investing in companies with competitive advantages or MOATs is typically recommended for long-term investors. However, it’s important to note that investors can still make money in markets without investing in such companies. In fact, I’ve personally made a decent amount of profit from companies with poor fundamentals, but this was usually over shorter time frames or with early-stage businesses that didn’t meet expectations.

I mention this because it’s important not to get swept away by the belief that investing only in MOAT companies will lead to profit. If you’re investing for the long term and have the patience and discipline, then finding quality companies still growing with a competitive advantage is an excellent strategy.

By implementing competitive advantage as a criterion in your investment process, you’ll naturally end up with higher-quality companies. Although these companies may be priced higher, they can often be purchased at a discount due to “Mr Market”. This strategy suits long-term investors because it aligns with a buy-and-hold approach until the MOAT breaks, or the thesis fails. Compounding your capital for a decade or two in such companies with attractive qualities can work wonders.

In Summary…

Understanding competitive edge is a crucial area of expertise for any business owner or investor. Having built, scaled, and exited various companies, I have gained experience in this field. Staying ahead of the competition has always been a top priority for me. I refer to it as a “Beachhead” strategy – land, deploy barriers, protect, and expand. Investing in companies that are well-positioned in their industry is a wise choice. It ensures that the capital I invest can compound and be protected.

This is where the Investment Process comes in. It involves conducting in-depth research, not just analysis, but asking questions that other investors might not. I look at industry trends, study business models, competition, and how companies develop favourable unit economics.

Understand innovation and disruption because sometimes a company can get turned on its head within an instant by something it never saw coming.

That’s why this blog emphasizes the importance of understanding business drivers and capitalism. Often, investors get too caught up in fundamentals and forget that knowing the drivers of business and capitalism can be equally important.