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5 Types of Investment Moats: Part 2

Castle Moat 2
Castle Moat 2

This is a continuation of a series of articles on competitive moats as adapted from the book “Why Moats Matter” from Morningstar.

Part 1 can be found here, and covers the main aspects of intangible moats.

This section will touch on the remaining moats – switching costs, efficient scale, cost advantage, and network effect.

Remember that you should assess each investment you plan to make to see if the company has any one of these moats.

Switching costs

Switching costs represent the cost and effort needed for a customer to switch from one supplier to another.

The higher the switching cost, the more reluctant the customer will be when it comes to changing suppliers.

If the offering is a service, it may involve service disruption and considerable hassle.

A good example would be banking software companies that provide core banking systems to clients, which may include large national banks.

Once the software is installed and training provided to all staff, it will prove extremely disruptive and costly to switch vendors due to the downtime involved and effort in re-training all the staff.

Hence, even if another vendor provides superior system functionality, the bank may not be willing to switch.

Network effect

The network effect is one of the most powerful moats in the business world.

Once properly built and in place, it is very difficult to topple.

The effect makes a service more valuable as it increases in size and scope because the value of the services provided increases in tandem with the number of users on the platform.

The network effect is most pronounced for internet-based businesses that allow transactions between buyers and sellers, as well as social networking sites.

It becomes a virtuous cycle when more people sign up on the platform, making it more attractive and desirable, which then goes on to attract even more people.

Cost advantage

Cost advantage refers to a business that has a distinct and sustainable cost advantage over its rivals.

As such, it can continue to produce its goods more cheaply compared to its competitors.

Possible reasons may include – the location of its factories (access to water or proximity to mineral resources, hence lowering transportation costs), better terms with its suppliers (bulk discounts) or process advantages (e.g. being vertically integrated).

Efficient scale

This is a relatively new moat which was defined only in 2011 by Morningstar.

Efficient scale describes a situation where a firm or group of firms serve a unique and niche segment.

With just a small market size, it will be uneconomical for larger, more established firms to compete as it would drive down the overall returns for the segment and cause all firms to suffer losses.

Such a moat must be carefully evaluated as there are not many such examples around.

In the next article on moats, I will look at moat trends to determine how and why some moats weaken or strengthen over time.

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Disclaimer: Royston Yang does not own any of the companies mentioned.

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