moat investment

Understanding Moat Investment: A Comprehensive Guide for Beginners

Traditionally, a “moat” is the water around a castle. This served as protection for the people inside the fortress against outsiders. However, in investment terms, a moat is defined as a durable competitive advantage that an organization uses to protect itself from attacks by competitors.

Companies such as Coca-Cola are renowned for having the biggest, sustainable competitive advantages over the other brands. A business moat is essential because it makes future results of an organization quite predictable, making it easier to put a value on the business.

As an investor, the moat is quite important. Before you start investing, you need to go for companies with at least one moat. It would be best to have an actionable investment strategy that looks into sectors with strong business moats. Otherwise, it will negatively impact your finances. Find out more on the best blue chip stocks in Singapore.

What is Moat Investment?

The concept economic moats was popularized by billionaire Warren Buffett. This form of investment is based on the concept that investors should put money in companies with sustainable competitive advantages trading prices.

Investors should prioritize such companies because they are more likely to stay ahead of the competition, which means higher fund returns. Moat investing is a smart way to gain financial independence and focus on the best-performing companies without trading issues. 

But you should also know the risks. 

Investing in a moat like Van Eck securities is subject to risk because there’s no guarantee of active trading market, fund shares trading, replication management, passive management, concentration risks, consumer staples, risk considerations of investing with Asian issuers, index tracking, elevated risks, new fund, and equity securities.

What is Network Effect and How it works?

The network effect occurs when the value of a product to its users increases proportionally to its use and the number of people using it. The more people use a product, it becomes indispensable.

Network effects enable a product to gain utility fast among a lot of people. As this happens, it helps the companies build a formidable business moat. Products with strong network effects can be quite challenging to outsmart or dislodge from the top. However, it’s not entirely impossible for a competitor to leverage the network effects.

The most durable moats in today’s world are built on advantages such as data, network effects, efficient scale, and repeat engagement. Companies that establish products with network effects are able to generate different kinds of business moats that make them better each time.

3 Kinds of Network Effects

There are different types of network effects that a product can have. Here are the main ones.

1. Marketplace Network Effects

This occurs when an organization attains a durable competitive advantage by bringing the suppliers and customers together in some kind of a marketplace. When more competing suppliers enter the marketplace, the services become less expensive. As more customers join the marketplace due to the low prices or quality products, more suppliers join as well, which drives competition and growth further.

An example of such a company is Amazon which leveraged marketplace network effects by reducing prices, decreasing shipping times, and expanding the inventory. By doing this, Amazon expanded from a small online bookstore to a strong global e-commerce platform.

Amazon’s business advantage is due to its ability to aggregate suppliers and customers. Their lower prices attract more customers, and more customers bring in more sellers. With time, Amazon has added retail verticals, new features, and marketplaces to fuel growth and increase user engagement.

2. Data Network Effects

This exists when a firm gains an advantage by collecting user data and making it more valuable. Companies that gather these kinds of data can use it to attract other users to their platforms as well as develop better algorithms that come in handy in building a better product.

Google is one such example. The information technology company built a durable competitive advantage using its search algorithms and used this information as a moat for its advertising capability. Their powerful data moat began with establishing better web search. 

Over the years, Google has built a dominance over search and used the data to solidify its advantage in shopping, transportation, and advertising advantage.

3. Platform Network Effects

A platform network effect occurs when the organization develops its competitive advantage by ensuring that the users stay within their product ecosystem. Platform moats are built to reinforce the main initial product and to add a layer with more value.

Companies that use this strategy develop every new successful product to make staying in the ecosystem more valuable. Apple is an expert in this. Their product iPhone is also known for its design and functionality. iPhone’s success has been because the company keeps improving the operating system and its ecosystem. The durability of the iPhone is that it incentivizes users to stick around.

What Is A Cost Moat?

If you look at the most prominent companies, the ones with the most durable business moats have got an advantage due to cost. Organizations that have a cost advantage are able to generate different types of business moats.

3 Kinds of Cost Moat

Coins with a Cost text and down arrows.

There are three types of cost moat. Let’s take a look at them.

1. Switching Cost

This moat exists when a firm sells a product that customers trust so much that they can’t switch providers. Such companies can drive their prices and profits upwards as long as the cost doesn’t exceed the total cost of switching to a competitor. In addition, even when it exceeds the switching costs, stickiness should protect the moat.

Slack is one of the companies using this moat. Organizations use Slack to organize internal communications, communicate with customers, and manage projects. Therefore, it becomes too hard to switch to an alternative tool. If companies change, they have to sacrifice the message history, workflow habits, chat channels, and time to invest in a new system.

2. Sunk Cost

Sunk cost moats work by prompting repeat payments from customers that should be big enough to dissuade the clients from leaving for a competitor. Therefore, the consumer’s perception is tied down to the initial investment they made on the product, which acts as a lock-in.

For instance, when Gillette started selling safety razors with disposable blades, they built a powerful business model based on sunk cost principle. Customers who buy their blades keep coming back, generating high-margin revenue from repeat purchases, and will have a tendency to stick around.

3. Cost Advantage

These moats operate in companies that build an efficient distribution and manufacturing process and provide lower prices than the competitors. This moat becomes powerful depending on how well a company keeps the costs below as they scale up.

GEICO outsmarted their competitors in by marketing their products such as health care insurance directly to the customers instead of using brokers. This gave them a significant leverage on price.

What Is Cultural Moat

Apart from cost and network effects, some companies build their moats, maintain their user base and fend off competitors by relying on intangible factors like tradition and brand. Basically, cultural moat is like banking on the value of the product in the consumer’s life. The more personal, the better. 

2 Kinds of Cultural Moat

Here are the two types of cultural moats.

1. Brand-Based

This moat protects the company from the competition by having a unique value proposition, messaging, and culture. Organizations get their customers to pay a premium for the products and to make repeat purchases based on the brand’s recognition.

Coca-Cola uses this moat to succeed. Although the company uses advertising and sponsorship, it has turned its soda to become the biggest brand in the world. In some countries, Coca-Cola is considered the best soda to have in any traditional gathering, as it brings happiness among friends and families. 

2. Tradition-Based

This type of moat protects the company based on the company’s beliefs, values, and culture. A company like Marmite has been culturally embedded in the UK. The organization’s growth is reinforced by the status as a traditional product which is primarily due to culture.

What is a Resource Moat?

Companies with a resource moat leverage on patents, internal expertise, and legal protections. Resources that are unique to the company are gained through R&D, monopoly, or internal knowledge.

3 Kinds of Resource Moat

Here are the three types of resource moat

1. Intellectual Property

IP moats exist when a company develops a valuable IP that its competitors structurally cannot use or replicate. A company like Pfizer spent $90 billion to purchase a competitor Warner-Lambert which built a patent-protected moat. Pfizer became invincible because no other company would sell the drug or a generic version.

2. Knowledge

This moat works by ensuring that you concentrate valuable expertise in an organization. This reduces knowledge loss by brain drain or imitation.

Canon built this form of moat by maintaining its internal engineering experience. Their investment in R&D made their copiers faster and smaller than their new competitors, making it easier for them to dominate and handle emerging market issues.

3. Regulatory

Regulatory resource moats exist where the company has protection from the competition through legal channels. A company like Coinbase has built a regulatory moat. As a public traded company, it can now scale and access the capital required to adhere to increasing crypto regulations worldwide.

Summary

As an investor, you should pay attention to economic moats, the company’s past performance, and check their summary prospectus. Companies with solid moats are more likely to bring more returns. 

The moat shares are redeemed at their net asset value through authorized brokers in a specified block of shares called creation units. Therefore, you’ll incur brokerage expenses. Pay attention to how a business protects itself before making cash transactions.

Key Takeaways

  • The biggest companies have multiple moats.
  • You should invest in a company that has at least one moat in place which determines its fund shares.
  • The most durable moats in today’s world are built on advantages such as data, network effects, and repeat engagement which affects future results.
  • The moat returns are affected by economic and political conditions, foreign currency fluctuations, currency exchange rates, foreign regulations making these investments volatile in price.
  • The past performance is not a guarantee of future results.

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