Legendary investor Warren Buffett famously coined the term 'economic moat' to describe a company that has the ability to maintain competitive advantages over its rivals in order to protect its long-term profits and market share from competing companies.
It is important at this stage to recognise that a typical competitive advantage is distinguishable from an economic moat. A competitive advantage is any advantage that currently allows a company to earn premium returns over its competitors. An economic moat, on the other hand, is a long term sustainable competitive advantage – a competitive advantage that will last even with the entry of new competitors.
Why is this important?
Businesses that generate high returns and margins will attract new competitors that will want a piece of the profits. Without some sustainable competitive advantage, market share can be eroded and margins can be squeezed.
It is generally accepted that there are five sources of economic moats:
- The network effect—Present when the value of a service grows as more people use a network.
- Cost advantage – Companies that can sell products or services at a lower cost than competitors due to economies of scale, market dominance and supplier relationships.
- Efficient scale – Present when a company serves a market of limited size and new competitors may not have an incentive to enter as this would cause returns for all players to be destroyed.
- Intangible assets – Brands, patents and licenses act as a strong barrier to entry and allows companies to charge more.
- Switching costs – Also known as the 'trap door' and refers to a situation where switching to a competitor is costly, difficult or inconvenient.
Many of the best companies will have a combination of economic moats and these are ultimately the companies that will be able to stand the test of time and continue to deliver superior returns to shareholders. Conversely, companies without an economic moat might enjoy brief periods of success but will ultimately succumb to competitive pressures.
Three companies with easily identifiable economic moats are REA Group Limited (ASX: REA), SEEK Limited (ASX: SEK) and Carsales.Com Ltd (ASX: CAR). They all benefit from the network effect, cost advantages and valuable intangible assets associated with their brands and unique technology.
Taking REA Group as an example, it has far more property listings on its website than its competitors. As a result, more people visit its site than any other which leads to a continuous cycle of more listings and more visits. This is a typical network effect and applies to SEEK and Carsales.com as well.
Leading market positions also allows these companies greater pricing control over their competitors. Remarkably, REA Group recently released its first half FY16 results that showed operating margins actually increased from 55% to 59% as more real estate agents were prepared to pay more for a premium listing on its website.
Some investors might argue these economic moats are only attributable to each of the business' domestic operations but each company is in fact delivering impressive growth in international markets. While they may not yet enjoy the market share they currently have in Australia, it is important to remember that Australia is made up of 24 million people – a tiny market in global terms. SEEK, for example, has rapidly expanded its operations into Asia and this is expected to be the company's new growth engine moving forward.
Foolish takeaway
REA Group, SEEK and Carsales.com all trade on significantly higher multiples than the market average – but these companies are far from average. Each has easily identifiable economic moats and significant growth opportunities in international markets.
Whether or not these companies will have truly global success is still in question, but it would be a brave person to write off any of these companies just yet.
