12/18/24
Moat Analysis
Author: Dhruv Kumar
Editor: David Sun
Companies with a strong competitive advantage often have "wide moats" which allow them to outperform the market by significant margins. In real life, a moat is a wide ditch typically filled with water to protect against attack. In the business world, companies with a “wide moat” may have lasting advantages over their competitors. The three categories of moats are wide moats (a strong competitive advantage), narrow moats (a weak competitive advantage), and no moats (with no competitive advantage).
The five sources of moats are network effect, intangible assets, cost advantage, switching costs, and efficient scale. The more sources a business has, the more likely it is to remain profitable in the future and resist competitors.
Network Effect: The greater the reach of a product/service, the more valuable it becomes to existing and new users. As more customers join, a cycle of attracting more users becomes harder for competitors to catch up. Examples include social media platforms and online marketplaces such as Instagram and Amazon.
Intangible Assets: These non-physical factors give a company a competitive edge. Some factors include brand strength, patents, and regulatory licenses. Patents and regulatory licenses limit competition, complicating competitors' ability to dominate.
Cost Advantage: Companies that can produce products/services at lower costs than competitors can sell at the same price and earn more profit, or they can sell at a lower cost, attracting more customers and gaining more market control.
Switching Costs: This gives a company pricing power by locking customers into its services. This can also be measured by the effort and time it takes to switch to a competitor.
Efficient Scale: When a company serves a market limited in size, the threat of new entrants decreases as their returns would be equivalent if not less than the cost of capital. This eventually leads to a natural monopoly.
Morningstar is the financial services firm that created these five sources. Although there are many advantages, Morningstar itself has acknowledged that its rating system is a quantitative measure of a fund's past performance and isn't intended to predict future performance.
*Key Definitions:
Patent - Consent from the inventor to make/use/sell their invention for a specific period of time.
Regulatory Licenses - Official permission from the government to operate in a certain industry.
Monopoly - A market structure consisting of only one seller.
Quantitative measure - The measures of values or counts are expressed as numbers.