Economic moats make a difference between being sustainable and not
Have you ever thought about what makes a great business? Or what keeps a great business great?
Besides the product, there are other forces that come into play in keeping the business afloat. Even great and world renowned businesses that fail to ride the wave of the market will surely fail, by having to constantly keep watch over some of the market forces they can prevent that.
As we can see, the process of defining economic moats is a live process, ever changing as the market does, but it is defined in the Business Model since the inception of the Product. It serves to guide the business from the fit of the solution to after the business has achieved product / market fit and is now in the process of scaling.
The competitive landscape becomes even more pregnant when the business has achieved scale, because a bigger organization will have increased overhead of adapting to change, due to new organizational structures. The more you add, the more the decision process will take.
Many organizations have struggled with this aspect, trying to have the same flexibility as a startup while scaling further and further, some of them have managed just that, but we will talk about that in a different post.
Coming back to our competitive landscape and what drives the forces that in the end decide what strategical “position” you take within the market ( aka economic moat ), we will now try to define what exactly is an economic moat and what to look out for.
Porter’s Five forces
As a brief history, Harvard Business school professor Michael E Porter in 1979, developed a framework of classifying the competitive landscape into 5 forces. It was a period when businesses sought to position themselves in an industry for long lasting success.
Before diving into economic moats, let’s clear the variables, the building blocks that each business has to play with, the bricks that define all Porter’s forces. These are:
- Real product differentiation: Think of superior features, think of the Kano model;
- Perceived product differentiation: Brands, perceived need, think of bottled water, think Tiffany’s;
- Driving costs down: offering the product at a lower price;
- Locking in customers: by creating high switching costs for the customer, usually that means time, think anything that a customer needs training for, think dentistry equipment, medical equipment and something more closer to our heart, think smart homes and smart home equipment providers;
- Locking out competitors: high barriers of entry, think patents, think regulatory exclusivity, think exclusivity contracts with a vendor for eyelashes glue for cosmetics, if a contract is settled, practitioners of cosmetics, will not be able to make cosmetics improvement for their clientele unless they buy the glue from a specific vendor, who has monopoly.
Now that you have an idea of what builds these forces, let’s go one step higher. We’ve discussed particles, now we’re zooming out with a proverbial microscope and we will be discussing atoms or what makes an economic moat:
- Threat of new entrants: This happens in an industry which has low barriers of entry. These markets are called Monopolistic Competition, like your favorite brand of restaurant. If you are hungry, any restaurant might do and the brand will not prove any longer a distinguishing feature. An example of huge barriers of entry are the Utilities companies or Pharmaceutical industry. Think of patents for pharmaceutics;
- Threat of substitutes: When trying to figure out what the substitutes for your product or service might be, you’ll have to get creative. For example, if you offer financial education as a digital service, a substitute would be Google’s search engine. Coming back to food, if flour gains in price, a slice of pizza might cost more to make, so a substitute would be a sandwich or a hotdog;
- Bargaining power of buyers: Think of airline industries, here, in order to provide the best service or more quality service than their competitors, a business will have to focus on driving costs down. Think of airline industries, think of major food retailers. By using the advantages of economies at scale, the bigger the size, the lower the price. In the case of airlines, think of logistics of fueling, seat placement and services offered;
- Bargaining power of suppliers: It’s one of the driving forces of the cost, it influences the previous point. If we think of airlines and of huge food retailers, we should think of the vendors of oil for the airplanes, seats, food, maintenance, etc. if we think of food retailers, we should think of individual farmers, importers/exporters and so on. A sudden change in their price, will affect the cost which is going to be reflected in the final price for the customer. In the case of a higher price for the customer, he/she might be predisposed of going to another provider of product/services which has other deals with other/the same suppliers;
- Rivalry among existing competitors: Is your business in a blue ocean or is your business in a red ocean? Think of the number of competitors in an industry, their number, their size, product differentiation perceived or real, etc. If you want an example, think of the entertainment industry, think of circuses and think of where “Cirque du Soleil” sits, by combining ballet, music and great costumes and shows, they developed their own niche, thus they are in a blue ocean ( a low competitor market ) distinguishing themselves from the other circuses on the market.
Disadvantages of Porter’s Five Forces
- They are backward looking. The best you can do is assess the current position in the market, but it provides more clearer view on what the market WAS, not what the market will be, it is a snapshot in time, more like the balance sheet if you will;
- It is very difficult to do the same analysis for the companies which have multiple product lines that spread over multiple markets.
As this framework was designed in the 80’ and currently the market is fast changing due to technology and globalization, this framework is good to be kept in mind and used with other tools.
Porter’s Five Forces can be made useful and relevant by using several streams of automation and digital data gathering, that gives you a rough idea of the overall market of the industry where you’re activating.
For public companies there are data providers called Data Vendors that offer company financial data, a wide range of financial indicators and ratios. This data can be aggregated and by using a graphical tool and looking at some metrics ( to be discussed further ) we can have a relevant view upon the market and industry.
This data is of course, gathered by the Data Vendors at the time of the companies make available their quarterly statements, so the image of the market will be quarterly.
For private companies, it will take a little bit more effort to gather data for an economic moats analysis.
Not required to make their financial statements public, all that can be done is to gather data from multiple statements and make assumptions and estimations.
Some countries require some sort of data to be posted by private companies, but they are not sufficient to make relevant observations, either by lack of or the frequency required by the fiscal policy makers in each country where the analysis is made.
If you’re interested on what data to gather from financial statements to have a rough overview of whether or not a company has achieved an economic moat, I have written an article regarding which financial indicators give more insight into economic moats here.
You can think of economic moats within two dimensions:
- Width: How wide the moat is, if you look in the image above, we can say the moat is wide enough to keep the attackers at bay. The breadth of the economic moat represents how long a company can show high net margins on a consistent basis, meaning keeping competition at bay;
- Depth: How deep the moat is means how much money a company can make.
Given these two dimensions we can have endless combinations ( being a real number, think of ranges/sliders that can be adjustable in both the width and depth as independent metrics ).
Example businesses use-cases
For example, technology companies can have a narrow and deep economic moat. You can think of the image on the left as Intel.
Why? Because as we’ve previously mentioned the 5 factors that make Porter’s five forces, technology companies usually set themselves apart from their competitors by: real product differentiation aka superior technology and features and by driving costs down by using mass-scale production, automation or by investing in technology to reduce the costs.
The moat using real product differentiation and by driving costs down is usually a short-term strategy, so a narrower moat. Superior technology can be rapidly caught up by the competitors and in the case of Intel, this is exactly what happened when Apple decided to make it’s own chips, thus taking a huge bite of Intel’s market monopoly as a chip maker.
Following an example from recent news:
Apple started using Intel’s processors in 2006 and a year later all Mac computers featured its chips. Since then, Intel has made chips for other Apple products such as modem chips for its iPhones.
Apple has always relied on outside suppliers for its modem chips, a crucial part that connects devices like the iPhone to wireless data networks.
In a bid to make its own chips, Apple bought a majority of Intel’s modem business last July for $1 billion and settled a long legal battle with supplier Qualcomm Inc (O:QCOM) over the chip-maker’s patent licensing practices.
Apple’s Mac computers generated $7.16 billion in revenue in the last reported quarter while Intel’s PC unit that includes modem chip sales recorded $10 billion in sales in the last quarter.
Apple was planning to use its own chips in Mac computers beginning as early as 2020, Bloomberg had reported https://in.reuters.com/article/apple-mac-intel/apple-plans-to-replace-intel-chips-in-macs-with-its-own-bloomberg-idINKCN1H91N8 in April 2018.
Another big company that is faced with decisions regarding it’s economic moat is Procter&Gamble. A world-renown company which has some good perceived need like brands that everyone had at least once in it’s house hold, brands like: Pampers, Ariel, Tide or Gillete.
P&G may have good perceived value but one aspect where it needed covering was real product differentiation by having a presence in the online. P&G was mostly a brick&mortar business, having no real stake in the online business, some of the competition began taking a share out of some of P&G brands, like Gillete. Brands that offered shaving products for men that we’re heavily rooted in the online industry, took P&G from 70% in 2017 to 50% for the US market. And these were not even big names: Dollar Shave Club and Harry’s.
Fortunately they’ve made a change, with the relative new CEO David Taylor ( November 1, 2015 ), the company now is steering more towards e-commerce than ever before. In 2019 it shifted most of their energies to promoting their products online and even using Google Cloud’s artificial intelligence tools to calibrate their marketing messages.
And just in time for the pandemic, right? People were stuck at home with remote working and were less inclined in “browsing the aisles” of a crowded shop, preferring ordering online vs in-person shopping.
With the result of this bold move, P&G doubled it’s revenue from it’s online e-commerce activity.
Although there aren’t any guidelines or good recipes for how to succeed in a highly competitive market place, a good rule of thumb will be to always take note of the market forces that could potentially disrupt your business, keep developing your moat and be on the lookout for other economic moats developing in your industry.
Simply by knowing these forces and planning in advance you can secure your position in the market and maintain your profits for a longer time, all the while building a heavy brand.
Gathering data dynamically and putting forward a plan to secure an economic moat early on, can make a huge difference for when the business scales.
Once at scale, keeping a constant look on the competitive advantage and leveraging data and other practices ( such as Lean and Agile ) can help you retain the competitive head-start even when you’re company has reached a critical level.
- Porter’s Five Forces explained by the Corporate Finance Institute
- Warren Buffet on Economic moats
- The little book that builds wealth – Pat Dorsey
- Morningstar on Economic Moats
- Positioning: The battle for your mind – Al Ries
- Blue Ocean Strategy: How to Create Uncontested Market Space and Make Competition Irrelevant