Stock Investing: 7 Types of Moats and How to Find Them
Stock market investing requires a deep understanding of the companies in which you invest. One of the most critical factors to consider when evaluating a company’s long-term potential is its competitive advantage, often referred to as its "moat." A moat is a company's ability to maintain a competitive edge over its rivals, protecting its market share and profitability from competitors. This concept, popularized by Warren Buffett, is crucial for identifying companies that can sustain their success over the long term. In this article, we'll explore 7 different types of moats, how to evaluate a company’s competitive advantage, and examine real-life examples of companies with strong moats.
What is a Competitive Advantage (Moat)?
A competitive advantage, or moat, is the unique feature or combination of features that allows a company to outperform its competitors. It can come from various sources, such as brand strength, cost advantages, network effects, or intellectual property. Companies with strong moats are better positioned to generate consistent profits and withstand market challenges, making them attractive long-term investments.
Types of Moats and How to Identify Them
There are several types of moats that a company can possess. Understanding these different types can help you assess whether a company has a sustainable competitive advantage.
1. Brand Power
What It Is: A strong brand can create customer loyalty, allowing a company to charge premium prices and maintain market share even in a competitive environment.
How to Identify It: Look for companies with high brand recognition, consistent demand for their products, and the ability to charge higher prices without losing customers.
Example: Apple (AAPL) is a prime example of a company with a powerful brand moat. Apple’s brand is synonymous with innovation, quality, and status. This brand power allows Apple to charge premium prices for its products, like the iPhone and MacBook, and maintain a loyal customer base. Despite the presence of cheaper alternatives, many consumers prefer Apple products, illustrating the strength of its brand moat.
2. Cost Advantage
What It Is: A cost advantage allows a company to produce goods or services at a lower cost than its competitors, enabling it to offer lower prices or enjoy higher margins.
How to Identify It: Identify companies that operate at a lower cost due to economies of scale, efficient production processes, or access to cheaper raw materials.
Example: Walmart (WMT) exemplifies a cost advantage moat. Walmart’s vast network of stores and efficient supply chain management allows it to buy in bulk and negotiate better deals with suppliers. This cost efficiency enables Walmart to offer lower prices than many of its competitors, attracting cost-conscious consumers and maintaining its position as a retail giant.
3. Network Effect
What It Is: The network effect occurs when the value of a product or service increases as more people use it. This creates a self-reinforcing cycle that attracts even more users, making it difficult for competitors to catch up.
How to Identify It: Look for companies whose products or services become more valuable as their user base grows. Consider factors like user engagement, growth rate, and the presence of barriers for new entrants.
Example: Facebook/Instagram (Meta Platforms, Inc.) (META) benefits from a strong network effect. The more people who join Facebook, the more valuable the platform becomes for each user, as it allows for broader social connections. This network effect has created a significant barrier to entry for new social media platforms, helping Facebook/Instagram maintain their dominant market positions.
4. Intellectual Property
What It Is: Intellectual property, such as patents, trademarks, and proprietary technology, can provide a company with a legal monopoly over its innovations, preventing competitors from copying its products or services.
How to Identify It: Evaluate a company’s portfolio of patents, trademarks, and other intellectual property rights. Consider the length of protection these rights provide and how critical they are to the company’s products or services.
Example: Merck & Co. (MRK) is an excellent example of a company with a strong intellectual property moat, particularly in the pharmaceutical industry. Merck’s success is largely driven by its portfolio of patented drugs, most notably Keytruda, an immunotherapy used to treat various types of cancer. Keytruda has become one of the world’s best-selling drugs, generating billions in revenue for Merck. The drug's patents protect it from generic competition, allowing Merck to maintain market exclusivity and command premium pricing.
Merck’s research and development capabilities further strengthen its intellectual property moat. The company invests heavily in R&D, continuously developing new drugs and expanding the approved uses of existing ones. This not only extends the revenue-generating life of its products but also enhances Merck’s ability to stay ahead of competitors by bringing innovative therapies to market. The combination of strong patents and a robust R&D pipeline ensures that Merck maintains its competitive advantage in the highly competitive pharmaceutical industry.
5. Switching Costs
What It Is: High switching costs occur when customers face significant inconvenience, expense, or risk in switching to a competitor's product or service. This creates customer stickiness and loyalty.
How to Identify It: Look for products or services that are deeply integrated into a customer’s daily life or business operations, making it costly or difficult to switch to an alternative.
Example: Microsoft (MSFT) demonstrates a strong moat through high switching costs. Microsoft’s Office suite, including Word, Excel, and PowerPoint, is widely used across businesses and individuals. The cost and effort required to switch to an alternative office software suite, coupled with the need for compatibility with others who use Microsoft products, create significant switching costs, helping Microsoft retain its market dominance.
6. Duopoly and Network Effects: Visa and Mastercard
What It Is: A duopoly exists when two companies dominate a particular industry, creating significant barriers to entry for other competitors. Combined with network effects, this can result in a powerful moat.
How to Identify It: Look for industries where a few players control the majority of the market share, and where the value of the product or service increases as more people use it.
Example: Visa (V) and Mastercard (MA) are prime examples of companies with a moat built on a combination of duopoly and network effects. These two companies dominate the global payment processing industry, with an extensive network of merchants and consumers who rely on their services for transactions. The more merchants that accept Visa and Mastercard, the more valuable these networks become to consumers, and vice versa. This creates a strong barrier to entry for potential competitors. Additionally, the sheer scale of Visa and Mastercard's operations allows them to operate with high efficiency and lower costs, further solidifying their dominance in the industry.
7. Natural Monopolies: Waste Management (WM) and Waste Connections (WCN)
What It Is: A natural monopoly occurs when a single company (or a very few companies) dominates an industry due to high barriers to entry, such as the substantial capital investment required, regulatory hurdles, or the need for extensive infrastructure. In these situations, competition is minimal because it is not economically feasible for new entrants to challenge the established players.
How to Identify It: Look for industries where a few large companies dominate, primarily because the cost of entry and operation is prohibitively high for potential competitors. Additionally, assess whether these companies benefit from regulatory protection, such as long-term contracts with municipalities.
Example: Waste Management (WM) and Waste Connections (WCN) are leading examples of companies with a natural monopoly in the waste management industry. These companies operate in a sector where the high cost of infrastructure—such as landfills, recycling facilities, and a vast network of collection routes—creates significant barriers to entry. Furthermore, waste management companies often secure long-term contracts with municipalities, providing them with steady revenue streams and further discouraging competition.
As a result, Waste Management and Waste Connections enjoy strong, sustainable competitive advantages, allowing them to maintain and grow their market share with relatively little threat from new entrants. This natural monopoly status helps these companies generate consistent cash flow and profitability, making them attractive long-term investments.
How to Assess a Company’s Moat
When evaluating a company’s moat, consider the following steps:
Analyze Financial Metrics: Companies with strong moats often exhibit consistent revenue growth, high and/or consistent profit margins, and a strong return on equity (ROE) — ideally an ROE higher than its cost of capital or higher than 10%. These metrics indicate the company’s ability to maintain profitability and market share over time. We generally wouldn't consider an unprofitable company to have much of a competitive advantage.
Let’s look at the return on equity of AAPL, for example. As you can see, it is extremely high (160%) and has trended upward in recent years, clearly indicating a competitive advantage. Its return on invested capital (ROIC) and cash return on invested capital (CROIC) have also trended higher.
Its gross profit margin (shown below) also shows that it has a competitive advantage. If it was trending notably lower over several years, it could be an indication that it was losing its competitive edge. That could mean that competitors have stepped in and caused AAPL to not be able to charge as much for its products/services relative to its costs. However, this isn’t the case, since its margins have trended higher over the years.
Understand the Industry Landscape: Evaluate the competitive environment. If the industry is crowded with competitors offering similar products at lower prices, the company may not have a strong moat. Conversely, if the company is a clear leader with few viable alternatives, its moat may be robust.
Consider the Company’s History: A long track record of success, even through economic downturns or industry changes, can indicate a durable moat. Look for companies that have maintained or grown their market share over time.
Evaluate the Sustainability of the Moat: Not all moats are permanent. Technological advancements, regulatory changes, or shifts in consumer preferences can erode a company’s competitive advantage. Assess whether the company’s moat is likely to endure or if it’s at risk of being undermined.
How to Find Stock with Moats — Check Out This Screener
Using the criteria we talked about above, we can make a stock screener to find stocks with competitive advantages. Using Finbox for the screener below (link here), we input the following criteria:
5-Year Gross profit margin CAGR greater than 0% — this will give us stocks that have grown their gross profit margin over the past five years, or at the very least, kept it flat, which is still fine.
Market cap over $1 billion — this is arbitrary. It doesn’t have to be $1 billion. A bigger number will probably give you companies with bigger moats, but it’s up to you.
Five-Year Return on Equity CAGR Greater than 0% — Similar to the first one, this will give us stocks that have grown their ROE over the past five years.
5-Year Average return on common on equity greater than 10% — this will give us companies that have been very profitable over the past five years.
Return on common equity greater than 10% — this will give us companies that are currently profitable.
Cash return on invested capital (CROIC) greater than 10% — similar to ROE, but CROIC uses free cash flow, so we’ll get companies that generate cash flow.
Five-year revenue CAGR greater than 0% to give us companies that are not declining.
Finally, I picked the following sectors to screen: consumer staples, communication services, consumer discretionary, healthcare, tech, and industrials.
Of course, this criteria is adjustable, but this is just a quick example of how a screener could be done. Check out the screener below. It spit out 117 companies that meet the criteria, and you can see some of them in the screenshot.
Conclusion
Evaluating a company’s competitive advantage, or moat, is crucial for assessing its long-term potential as an investment. Companies with strong moats are better positioned to withstand competition and continue generating profits, making them attractive long-term investments. By understanding and identifying different types of moats—such as brand power, cost advantages, network effects, intellectual property, duopolies, natural monopolies, and switching costs—you can make more informed investment decisions and build a portfolio that stands the test of time.
Whether you’re looking at giants like Apple and Walmart or exploring opportunities in emerging companies, assessing the strength and sustainability of a company’s moat is a key step in identifying investments that can deliver consistent returns over the years.
