Whenever we tend to buy something, it makes logical sense to pay more for something of better quality than a low one. Be it ranging from cars, to houses, or even daily commodities, items of quality generally commands a premium price because the higher-up front cost will be deemed acceptable for the durability or quality of products. This is why Honda cars cost more than Kia cars and contractors quality tool cost more than those from cornerstone hardware store, etc. So similar to looking out for quality products, identifying economic moats when it comes to investing is a crucial part of the process.
Having this concept in mind, did you know that you can actually apply the same principles in the stock market? Let’s put it this way, for companies that have strong competitive advantages, they are usually durable, and this is particularly important to you as an investor. So consider companies’ economic moat as a structural business characteristic that allows a company to generate excess economic returns for an extended period. Usually, there will be a higher probability that the company can distribute excess returns to the stakeholders if the company is able to generate excess economic returns.
To understand why moats increase the value of companies, we must first understand what determines the value of a stock. Always bear in mind that a stock is a representation of ownership in a company. The value of a stock is equivalent to the present value of cash that it is expected to generate over its lifetime, minus the company expenses needed to maintain competitiveness and/or for expansion. Do you agree that the dollar in your hand now is more valuable than a dollar that you receive in the future? In the same context, the cash that we are confident of receiving in the future is worth more than the cash flow that we are less certain of receiving.
This is why the company with a moat is worth more today: simply because it’s able to generate economic profits over a longer stretch of time. In a similar fashion, a company with a moat that is likely to compound the cash flow internally for many years is worth more than a company without a moat. So when you buy the shares of a company with a moat, you are buying a stream of cash flow that is protected from competition for a longer stretch of time.
Now let’s take a look at the four main types of moats:
Companies with this moat are those that can deliver their goods or services at a low cost, typically due to economies of scale. They also have a distinct competitive advantage because they can undercut their rivals on price.
Switching costs are those one-time inconveniences or expenses a customer incurs in order to switch over from one product to another. 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–so there would have to be a really good reason, like a package deal on an account and mortgage for example, for you to consider switching again.
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.
The network effect is one of the most powerful competitive advantages, and it is also one of the easiest to spot. 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.
Some companies have an advantage over competitors because of unique nonphysical, or “intangible,” assets. Intangibles are things such as intellectual property rights (patents, trademarks, and copyrights), government approvals, brand names, a unique company culture, or a geographic advantage.
As investors, we might ask ourselves: is it possible for some companies to have more than one type of moat? Absolutely! For example, many companies that use the network effect also benefit from economies of scale, because these companies tend to grow so large that they dwarf smaller competitors. In general, the more types of economic moat a company has, and the wider those moats are, the better.
Now you know why moats should matter to you as it increases the value of companies or adding intrinsic value to the company. Identifying moats will give you a big advantage on selecting which companies to buy and also on deciding on the price to pay for it.
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