Want To Build A Massive Business? Build A Moat Around It First!

Advice, Reports and Strategy

January 21, 2020

Building an economic moat means creating a long-lasting competitive advantage that other businesses can hardly replicate. There are 4 main kinds of moats.

According to Investopedia, “the term economic moat, popularized by Warren Buffett, refers to a business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms. Just like a medieval castle, the moat serves to protect those inside the fortress and their riches from outsiders.

As users and customers, we experience the effects of these moats on a daily basis, without even realising. Creating a long-lasting competitive advantage often relies heavily on the regulatory, cultural and social environment where a business operates. In the longest term, hardly any moat will withstand the test of time, and with new technology, new laws and new user trends, new moats take over the old ones.

As ever-changing as they can be, moats – according to a recent CBInsights report – can be divided in 4 main categories, each of which has its own subcategories with the respective case studies.

Network Effects

Network effects have been popularised by the recent wave of social media platforms, two-sided marketplaces and AI-powered services relying on high quantities of data. All these business categories are heavily reliant on network effects to differentiate themselves from their competitors.

The presence of a network effect implies that the product or service increases value as its user-base increases. This is typically the case with new media of communication, like the telephone: the value of the telephone was much lower when only a handful of people owned it, but became indispensable as soon as everyone had one in their home.

For companies operating in these spaces, leveraging network effects is the key to create an economic moat – and therefore competitive advantage: once all of your friends are on TikTok you surely won’t spend as much time on Instagram!

Three main types of network effects are most commonly found in the most prominent contemporary case studies:

  • Marketplace – think Amazon, Uber and Deliveroo. When a company brings together providers and users of a specific service, there is a mutual benefit for both parties to be on the platform. As more providers populate the marketplace, users have more choice and access to lower prices. In turn, more users attract even more providers, and the cycle goes on in a self-reinforcing loop – if everything goes well!
  • Data – when a company has the capability to leverage its user data to improve its product – or create a new one altogether – they are usually able to create a data network effect. The more users, the more data is gathered, the better the product gets. This was the case for Google, which leveraged data gathered using its search engine to become an advertising titan. AI companies that rely on huge datasets to train their algorithm also often try to build an economic moat by leveraging data network effects.
  • Platform – think product ecosystems like the Apple product family, or the Windows OS. Creating a network of complimentary products that are only compatible with each other gets more and more valuable as adoption of these product increases. That’s how the Microsoft Word format became the standard, forcing other players out of the office software segments, as well as how Apple made tens of billions from their share in App Store sales.

The big issue with network effects is that it takes a while to initiate them and a lot of effort to maintain them. Many companies have tried to build an economic moat based on network effects. Sometime they succeeded, but only temporarily.

Leveraging network effects means mastering the art of user acquisition by making it cheaper and cheaper over time and keeping users engaged as the product becomes more valuable with adoption growth, meanwhile building up switching costs that make it less and less appealing for customers to leave.

Cost

Being able to reduce the cost of providing a product or service in a way that no other competitor is able to do, constitutes one of the most common and durable kind of economic moat.

Cost advantages can be obtained in different ways: direct-to-customer business models are a now-popular way of trying to disrupt an industry with a long supply chain by undercutting incumbents; vertical integration, such as cutting costs by gaining direct access to the raw materials needed to manufacture a product, is a more classic example.

Regardless of how the advantage is obtained, the way it is presented to the customer makes the real difference in the kind of economic moat that is created as a result.

  • Switching cost – when a company can afford to charge their customers more (at a higher margin) because it would still be more expensive for users to switch to a competitor, they successfully built an economic moat on switching costs. That was one of the main reasons for IBM’s early success.
  • Sunk cost – similarly to switching costs, products and services which involve some sort of initial economic commitment from the user make them unlikely to want to switch, as they would lose that initial investment. This is the rationale behind all business models based on products with disposable parts, such as Juul e-cigarettes or Instax cameras.
  • Cost advantage – economies of scale, vertical integration and direct-to-customer models are only a few of the most common techniques used by companies to undercut their competitor, automatically becoming consumer-favourites. Amazon mastered the leverage of this moat (as of many others), American insurer GEICO earned Warren Buffett’s praises (and investment) by going D2C.

Culture

Some of the world’s most successful companies built their fortune not on structural advantages, but rather on intangible assets that generate additional value to the customer in an intrinsically unique way.

Products and services that appeal to customers because of they symbolise and what they stand for, create a durable moat that can hardly be recreated by any competitors.

This is the case for all consumer products that regularly appear among the “most valuable brands” lists. Companies like Coca-Cola, Nike, BMW provide products that are certainly comparable to those of competitors in objective terms, but the power of a logo and everything it stands for constitute an inimitable value-added to the customer. Often, this kind of economic moat can only be narrowed with the help of a generational turnover, as powerful brands tend to generate loyal customers that won’t even contemplate the idea of switching to a competitor.

In some cases, these intangible assets are deeply intertwined with tradition and nostalgia. So much so that a company is able to completely push away competitors becoming the only provider of a specific product… think Marmite!

Resources

This last type of economic moat does not rely on the product nor the brand. Its advantage is rooted at the start of the supply chain, with companies capitalising on resources – concrete or intangible – only they have access to.

Leveraging this kind of moat often requires specific expertise in the legal and regulatory fields, in order to make sure that access to key resources remains restricted from competitors. Patents, government contracts and technical intel are the main tools used by these companies to defend their moats.

  • Intellectual Property – many products are based on (or constitute themselves) a technical advancement achieved through R&D, or an original creative asset that has been conceived from scratch. There are laws in place to make sure that such products cannot be replicated by others who did not contribute to their initial development. Companies in IP-intensive sectors such as pharmaceuticals and entertainment have learned that investing heavily in IP and copyright protection allows them to build a moat that legally cannot be overcome.
  • Knowledge – even when there are no patents or copyrights in place, specific and advanced technical expertise can help a company maintain leadership in an existing market, or even entering a new one as a leader. Amazon pivoting from online marketplace to web services provider with the introduction of AWS was only possible because they needed to become the leader in cloud-computing in order to develop their core business.
  • Regulation – although there is increasing pressure from customers and governments to regulate monopolies and oligopolies to encourage fairer competition, many companies thrived – and thrive – because regulators allowed them to grow while minimising the risk of other players entering the market. That’s the case for energy providers and phone carriers that were previously somehow backed by the government but managed to maintain high market shares because they were allowed to grow undisturbed for decades, such as AT&T in the US.

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