Moat Theory

In earlier days, moat was referred to a deep water-filled ditch that was built for defense around the castles as it was believed to prevent enemies from entering the kingdom. In reference to that, one can believe that companies are the modern-day ‘kingdom’ or ‘empire’ of the corporate leaders, that need to be protected from its competitors or ‘enemies’.

So, it is only fair that a moat is built around these companies to safeguard its main interests, profitability and market share.

Inspired from this concept, Warren Buffet, popularized the concept of ‘Moat Theory’. A company is said to have a moat if it possesses a distinct competitive advantage that sets it apart from the rival firms and secures a certain market share.

Majority companies try creating an economic moat which gives them a fair advantage over the others.

But, there is no one correct way or type of creating a moat.
It can differ in sizes, types, and are given appropriate ratings as well.

We’ll explain in brief what we’re talking about here, read on!

MOAT SIZES

Moats could be either narrow or wide.

NARROW MOATS

It pertains to companies that have some competitive advantage. They may not be the market leader in the particular sector yet, but provide a certain degree of differentiation against the rival brands. There are many more companies with narrow moats than the ones with wide moats. Although they have lower returns than the companies with wide moats, they manage to have returns slightly above their cost of capital.

This generally happens with firms with eroding moats that are witnessing a shift in the industry landscape. For example, Kelloggs K enjoyed a pricing power, however, that is gradually fading away owing to an increase in competition.

Just having a moat is not enough, companies must work towards widening them.

This can be done through continuous product development, marketing, distribution, and sales.

WIDE MOATS

Companies with these moats are said to have the strongest competitive advantage as compared to their peers. One would naturally go for a wide moat company product that offers distinct features and quality. Most of the wide moat companies have a structural advantage in their business model, like in the case of ITC. ITC has formed a unique business strategy and has a strong competitive advantage over its peers.

Needless to say, companies with NO MOAT have zero competitive advantage.

MOAT RATINGS

Moats are not static and change from time to time, given the different business environments, hence, they are rated based on the performance.

POSITIVE MOAT RATING

This is given to companies whose competitive advantages are improving.

NEGATIVE MOAT RATING

This is given when the competitive advantage is diminishing.

STABLE MOAT RATING

With no movement whatsoever.

DIFFERENT TYPES OF MOAT

We’ll now talk about the different types of moat in reference to different companies that have leveraged each kind for their benefit.

NETWORK EFFECT MOAT

This moat is all about building networks or social connections. A business environment thrives with suppliers on one hand who are eager to provide or “supply” their range of goods and services hoping to find consumers who would value such products. On the other hand, are consumers, who are on the lookout for suppliers to provide the products and services.

The network moat companies realised this and successfully aligned both these business parties!

It talks about the value provided to users which increases in proportion to its usage.Such a moat contributes to a product’s gain in utility by bringing together suppliers and customers in one marketplace.

SWITCHING COST MOAT

This exists when a company provides a product with distinctive features that consumers need or trust too much to switch providers.

COST ADVANTAGE MOAT

This exists when companies offer prices much lower than competitors owing to manufacturing.

CULTURAL MOAT

Brand based cultural moat creates a unique value proposition, characterized by repeated purchases and premium price.

RESOURCE MOATS

These moats are created by leveraging internal expertise, patents, legal protection.

In short, moat helps businesses gain an advantage over their competitors. It helps the businesses sustain and grow over the long-term. Every company should realize what their moat is, and work on the successful implementation of the same.

Contributor: Nidhisha Chaudhary
Research Desk | Leveraged Growth

I am a finance Graduate from Narsee Monjee Institute of Management Studies (NMIMS), Mumbai and currently pursuing CFA. A movie buff and foodie at heart, I firmly believe in working hard, as it has the power to beat talent, luck, and any shortcoming. I aim to infuse the business of commerce with a sense of purpose, and a notion of success which is beyond money.

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