The concept of “economic moats” came from a 1999 Fortune article by Warren Buffett:
The key to investing is […] determining the competitive advantage of any given company and, above all, the durability of that advantage. The services or products that have wide, sustainable moats around them are.
Economic moats stay tethered to investing: A bigger moat creates a stock a bet. But the implications are wider, for businesses large and small.
An effective moat doesn’t need Amazon’s distribution system or Microsoft’s software strategy. A moat-building project can be far easier while still working toward the same goal: a business advantage.
Developing a moat isn’t formulaic. But common features are shared by companies with moats. Understanding those, in turn positions one to answer the question, “Which approaches are most likely to build a moat for my company? ”
What’s moat the difference between a & ldquo & rdquo; and a & ldquo;rdquo & competitive advantage;?
Moats are one type of advantage. As Buffett suggests, they’re durable than other competitive advantages.
Baseball offers an analogy. A mid-season exchange for a player in a contract’s final year stipulates a short-term roster increase. It can give a team extra bat or the starter they should make a playoff run. But those players will depart at the season’s end.
A strong farm system, by comparison, takes more time to pay off. However, it delivers following year of fresh talent–talent that’s to come. Mid-season trades are advantages. Farm systems are moats.
Benefits are useful, but they shouldn&rsquo. There are two ways to build a moat:
Dig a wide moat. Wide moats rely on several factors. For instance, Salesforce has a powerful brand and exclusive integrations with Google Analytics 360. Sales reps are also likely to be familiar with Salesforce since it’s the most widely used CRM, reducing onboarding costs for businesses that use it.
Dig a deep moat. A deep moat is more difficult to overcome but isolated to one characteristic. For example, in the United States, freight railroads have a deep moat. The tracks are owned by them. An entrant would have to build a network of railways to compete independently.
“Efficient scale,” explored more below, is the deepest type of moat. Railroads enjoy scale. (Image source)
Still, not everyone thinks moats are a fantastic idea.
Warren Buffett, Elon Musk, and a fight over candy
One year ago, Buffett and Elon Musk got into a fight over candy. The feud started when Musk was asked about Tesla’s choice to create its network of fast chargers accessible to other automakers (for a fee). Why would Tesla let others use its network, which could be a moat to protect it from electric competitors?
“I think moats are helpless,” Musk responded. “It’s fine, sort of quaint, in a vestigial way. If your only defense against invading armies is a moat, you won’t last long. What matters is the speed of innovation. That’s the basic determinant of competitiveness. ”
When told of Musk’s comment’s, Buffett acknowledged that technological change has made moats more vulnerable but not irrelevant. “Elon can turn things upside down in some regions,” however, Buffett suggested, “I don’t think he’d wish to take us in candy. ”
Buffett’s company, Berkshire Hathaway, owns See’s Candies, and Buffett believes the company has a near-impenetrable moat, based largely on its brand. Musk wasn’t impressed:
I am super super serious
— Elon Musk (@elonmusk) May 5, 2018
Then I’m going to build a moat & fill it w candy. Warren B won’t be able to resist investing! Berkshire Hathaway kryptonite …
— Elon Musk (@elonmusk) May 6, 2018
Posturing aside, there was a clear debate. Musk believes that moats are largely illusory–and also lazy. They stifle innovation. They may delay company death, but they also make that death inevitable.
You can create a moat that jealously guards an advantage without extending it. Or you could build one that gets wider and deeper as you innovate. To a large extent, it is dependent upon the type of moat and how it’s deployed.
Five Kinds of moats (and examples of each)
There are five types of moats:
High switching costs;
Some moats have greater relevance (or irrelevance) for various industries.
1. Low-cost production
Takeaway: If you’re in a commodity business, be persistent when reducing costs–the lower you go, the deeper the moat.
If you can make it for less, you can sell it for less. Buffett, when thinking of low-cost production moats, utilizes GEICO (another Berkshire Hathaway acquisition) for instance. GEICO didn’t stumble upon low-cost production as its moat. It was essential for their economy:
Most people will assume that the service is fairly identical among [auto insurance] companies, or near enough, so that they rsquo;re going to get it done on cost, so I gotta be the low-cost producer. That’s my moat. To the extent my prices get further lower than the other man, I’ve thrown a few sharks into the moat.
When it comes to low-cost manufacturing, examples often focus on manufacturing and supply chain management. In Richard Rumelt’s Good Strategy Bad Strategy: The Difference and Why It Matters, he recounts a popular (and recurring) discussion with his students: What makes Walmart successful? And why is it so tough for others?
Obviously, Walmart thrives as a producer. However, what did it build which moat? The answer isn’t like buying in bulk, only the reduced costs that come with scale. It is, Rumelt explains, the direction of Walmart stores .
Costs are limited by the company through a distribution and management structure which serves multiple stores in a geographical area. Stores’ network allows Walmart to restrict its stock and share expenses. The moat is deep–efficiencies flow from a network.
Walmart’s low-cost production hinges on direction of its shops as a system –not the raw number of individual stores.
2. High switching costs
Takeaway: Customer data should enhance the user experience, not make it tougher for people.
More than any other moat, switching costs often serve businesses, not consumers.
Until 2004, when the U.S. Federal Communications Commission rolled out Wireless Local Number Portability, mobile phone service providers retained customers with higher switching costs. You lost your phone number if you left your provider. The moat offered consumers nothing but made it effortless for mobile phone companies to keep customers.
More recently, switching costs have centered on “info moats. ” The decision to migrate a company Basecamp to Trello dangers years of knowledge. Leaving Gmail would cost you your list of contacts or messages. (You could export them, but there’s still a cost.)
Interoperability isn & rsquo; t common, while contacts transfer to other providers. Many companies actively thwart interoperability. This is particularly true in health care, where electronic medical record (EMR) providers understand that making their data play nice with other systems empowers customers to switch.
EMR companies have built moats based on a lack of interoperability. It’s the type of self-serving strategy that Musk abhors. (Image source)
Given that the average hospital system utilizes 16 EMR suppliers , restricting interoperability protects an current system and offers fertile ground for growth. If an EMR provider rolls out a product, its interoperability in their system makes it a tempting option for clients. This is the moat-building which Musk bemoans.
Social networks have their own switching costs. Twitter and Instagram are strong platforms for brand building. Followers are funds that users store on the platform. Leaving–or splitting time to pursue fans on a network –comes at a cost.
That cost creates inertia that slows the development of new ones and keeps users on an existing network. It’s the point of overlap between switching costs and network effects.
3. Network effects
Takeaway: The positive impact of market share compounds–especially for applications adoption.
Uber and eBay have something in common. Newcomers who take on either must answer the question, “Why bother with you if nobody else is here? ” Both companies. Their goods become more valuable as they acquire users. (And competing products light in comparison.)
A startup taxi service needs tens of thousands of drivers in a town before wait times can compete with Uber. The choice on eBay–of goods (for buyers) or possible buyers (for sellers)–took years to build.
A business model that requires a network effect is a long play. A grind that is expensive hits a tipping point, when exponential growth delivers profitability.
For a network effect to take hold, the rate of growth for prices must stay constant as consumer growth accelerates. (Image source)
The network effect is a moat that is strong. It’s one that many venture capital–funded startups deploy. The principal objective is user acquisition. Profitability could be sorted out afterwards, as was the case with WhatsApp.
WhatsApp focused on driving user adoption, and Facebook purchased the company in 2014 without knowing how to monetize users. Zuckerberg felt that any platform with a half-billion users had possible, even if that required a $19 billion bet.
Zuckerberg paid, in other words, for the network-based moat: “WhatsApp is on a path to connect 1 billion people. Are all valuable. ” (By 2019, WhatsApp had 1.5 billion users–but no monetization. Uber isn’t profitable either.)
4. Assets Takeaway: A brand that is strong might be the deepest moat that businesses can dig to fend off business giants.
“Intangible assets comprise trademarks and patents,” writes Alex Graham, “but also hard-earned competitive advantages, such as brand names and culture. ”
Some “intangible” assets are more defined than others. Patents and trademarks are lines that are legal. Are regulations, which are a cynical campaign that is moat-digging. TechCrunch’s Josh Constine contested Facebook’s recent call for law as just such a ploy:
[Y]oung startups might be anchored by the burden of regulation. It could keep them from ever rising to become a true alternative to Facebook. Venture capitalists choosing whether to finance the next Facebook killer might look at the regulations.
Constine isn’t the only one with that opinion:
Facebook *needs privacy regulations to entrench its monopoly power. This is the reason the company is currently orienting towards protecting your data and discussing privacy. Zuckerberg does not want to talk monopoly. Follow. The. Money. https://t.co/tAKT5yAd3p
— Matt Stoller (@matthewstoller) April 9, 2018
Musk, by making his fast chargers available to other people and open-sourcing Tesla’s patents, has intentionally filled a possible moat. Doing so, in turn, has earned the company favorable publicity–publicity that digs on an adjoining moat.
In comparison to patents, brand is delicate. However, it has no expiration date. Digging a brand moat is no different than building a brand. Buffett still laments Kodak’s conclusion to allow Fuji to sponsor the Olympic Games:
Well, Kodak had that in spades, 30 years back, that. They had what I call share of mind […] the small yellow box and everything–that said, “Kodak is the best. ” That’s priceless.
They let Fuji come and begin narrowing the moat in various ways. They let them get into the Olympics and take away that aspect that just Kodak was fit to photograph the Olympics.
1 way to dig on a brand moat? Create a brand-owned term. HubSpot, that possesses & rdquo, & ldquo marketing; includes a brand moat, in part, due to its role. If other aspects of its brand diminish, it will always have the origin story of marketing.
Theyrsquo;ve inspired imitators, such as Drift, which coined “conversational marketing” if it intentionally entered a commodity market. Given the choice between building a moat based on low-cost production or intangible assets, Drift chose manufacturer. It’s worked out:
The black bar is when Drift committed fully to “conversational marketing. ” Its brand recognition has continued to grow using the term. Development of the term was a iterative process.
5. Efficient scale
Takeaway: If demand has company boundaries, aim for dominance.
Moats built on efficient scale apply to a small number of companies, like the aforementioned freight rail operators. They also apply to private businesses which enjoy monopolies on public utilities, like electricity.
Efficient scale moats depend on limited demand and geographical dominance. For example, it’s feasible to build a motor speedway in Indianapolis. But need won’t climb. The number of occasions or race fans won & rsquo;t double with second track’s availability. If you took that project without a raceway to a town, the economics could do the job.
Efficient scale relies on mergers and acquisitions when geography is the deciding factor. In the United States, the consolidation of health-care systems is a model for efficient scale moats: a rash of regional acquisitions.
Upstarts are deterred by a hospital system’s regional dominance. Constructing a hospital in a market served by a sprawling system won’t procedures or ER admissions.
They & rsquo; re the least relevant to businesses, because, in many cases, efficient scale moats were created decades ago. Technological change has created opportunities for new sorts of moats.
Moat-building in the 21st century
Innovation is a disrupter. It’s why Musk believes moats are irrelevant. But technology has also generated new moats.
HubSpot’s Brian Halligan contends that Zappos’ moat doesn’t rely on its supply chain–a competitive advantage, perhaps, but a shallow moat at best. Rather, he argues, the company has assembled a moat that was digital:
The reason that we don’t start a company to compete with Zappos isn’t [its distribution chain]. The moat around their business is both million links in their website. How are we going to do that? It’s the 10 million Twitter followers they have, the massive number of Facebook enjoys. You can’t wake up overnight and find that.
Note: As of April 2019, Zappos had 2.5 million Twitter followers.
The crux of Halligan’s pitch is inbound marketing’s value. A brand may be built by inbound marketing. But it also widens the moat with backlinks that are hard-won, in other ways and participated social media followings.
The capacity to reach large swaths of customers organically, via search, is a moat. The competitiveness in media and organic search has deepened that moat for new entrants.
There are parallels to Buffet’s more conservative approach and Musk’s free-for-all. Does a website and sites link with & ldquo; do follow & rdquo; hyperlinks? Is every effort made to keep users from clicking elsewhere–even if external links serve user attention?
What is the guiding principle: ambition or fear?
Pick a job description for a sales position. What are the chances that “understanding of/experience with Salesforce” is on there? Software adoption–a moat of network effect–can protect a business.
Our current stack: Customer.io, Intercom, Hull.io, WordPress, Heap, Hubspot Sales, Mailshake, Clearbit, Unbounce, Google Analytics, Google Tag Manager, Metorik.
Software could be learned. It’s not the moat. However, s position on the market.
It’s an interesting argument in favor of a freemium version of a SaaS product. A freemium version could train thousands of customers on your product, which makes it easier for companies with a paid version to locate employees that are ready-to-work.
Likewise widespread freemium adoption could motivate software companies to create integrations. Not surprisingly, the products–not or freemium –earn strong and early integrations. Those integrations can be lucrative, such as Salesforce’s integration with Google Analytics 360.
Facebook has assembled its moat with customer data. It’s so primarily to benefit advertisers, itself and, by extension. Customer data doesn’t work against the consumer.
For example, I’m reluctant to switch streaming music providers. Spotify’s recommendations are helpful now that I’ve spent thousands of hours.
If personalized recommendations are invaluable, they increase switching costs while still serving the consumer.
In other cases, consumers may not understand that they benefit from use of their customer data. This is easily exemplified by segmentation and personalization. The customer has a better experience, if your customer data permits you to deliver content that is more relevant. And you reap the benefits of engagement.
To build moats–not only competitive advantages–each strategy needs to answer two questions:
Does this attempt build a competitive advantage that is meaningful?
Does that competitive advantage also benefit consumers?
A focus on moat-building is unlikely to inspire approaches. But it adds urgency to the need to build multiple, sustainable advantages and does adjust the focus on. It may mean devoting ad spend to a brand campaign even if profits might be boosted by a one.
“Our managers of the companies we run, I’ve got one message to them,” says Buffett, &ldquo. And we would like to throw crocodiles and sharks gators, and everything else, I guess, in the moat to keep away competitors. ”
Detractors, like Musk, ask pointed questions about the costs of moat-building. Moats should serve consumer interests. They ought to encourage innovation. Technology has reshaped moats to be shallower and thinner.
No moat, however wide or deep, can protect a company from complacency.
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