Sources of Durable Moats: Building Blocks of Great Business

Warren Buffet has uncanny ability to transform hardcore business constructs into analogies that is very easy for common man to relate to yet effectively conveying the central idea behind the business construct. One such wonderful analogy he gives is about sustainable competitive advantage by comparing it with "moat". 


Moat is nothing but a big ditch, mostly filled with water, constructed around a castle, that acts as primary defense when the castle is under attacks from the enemy. Similarly, sustainable competitive advantage act as protective barrier for the company to retain its business/market share when under attack from competitors. Wider the moat around the castle, more difficult for the enemy to penetrate the defense effectively. 


Mr. Buffet only invests in businesses which have expanding "moats" built around them. However, the million dollar question here is, how does one identify whether a particular business has built "moat" around it or not. As to all million dollar questions, there is no easy answer! Even though, there can be umpteen factors/characteristics that can lead to sustainable competitive advantage for the business, six sources of "moat" can be attributed to 80% of the great businesses we see around us. 

In addition to describing sources of "moat", I will also try to enlist few companies which apparently possess such moat.

Strong Brands: Strong brands are the most prominent source of competitive advantage. At a subconscious level, strong brand occupies mind space of consumers and creates a very strong positive association with the product. We all know that some of the brands become so strong that brand itself is considered as product/product range. There are number of such brands existing in Indian market some examples as below

• Fevicol (used as substitute for adhesive) from Pidilite
• Prestige (Pressure Cooker) by TTK Prestige (now Hawkins also)
• Maggi (Noodles) by Nestle
• Nescafe (Instant Coffee) by Nestle
• Band Aid (Adhesive bandage) by Jhonson & Jhonson

It takes years to establish a strong brand. A strong brand not only creates a very formidable entry barriers for competitors but also gives substantial pricing power to the company against its competitors. Two such emerging brands with high quality businesses are Cera (Sanitaryware) and Astral (plumbing needs).

Distribution Network: A well laid out distribution network can act as a very strong moat for companies. This is especially true in country like India where a very sizable population stays in rural area and establishing "reach" of the product is difficult. It takes years of effort for a company to establish wide spread dealer/retailer network combined with optimized supply chain management. Maruti Suzuki is one such company which has "network moat" acting as primary line of defense against intense competition. Maruti has unmatched network of service centers spread across length and breadth of the country. Similarly spare parts for Maruti is available even the remotest part of the country. It will take years for new entrants to create such wide spread service network combined with easy availability of spares. I know many of friends/relatives who consider "reach" of Maruti as a key advantage over its competitors while making a purchase of four wheeler. 


Similarly, on consumer product side, a new entrant in coconut hair oil market has tough nut to crack to match combination of strong brand and unmatched distribution network of "Parachute" by Marico. 

Intellectual Property: An intellectual property such as patent or trademark or unique know how can provide company with sustainable competitive advantage. A prime example of such competitive advantage can be seen from MNC pharma company with patented drug that can give exclusivity to the company for 20 years. In Indian market, Vinati Organics is one such example. Vinati Organics is world's largest manufacturer of isobutylbenzene (raw material for ibuprofen) and second largest manufacturer of Acrylamido Methyl propane sulfonic acid (monomer having diverse applications in acrylic manufacturing, oil drilling, surfactant). Vinati Organics Limited has developed  unique manufacturing processes with the help of national chemical laboratory which is able to consistently produce product meeting international quality standards. It has long term supply contract with marquee list of clients such as BASF, Rohm & Haas and Akzo Noble. Again developing such unique process and fine tuning the process to meet exacting quality standards takes substantial amount of time and effort and hence protects company from intense competition.

Lowest Cost Producer/Economies of Scale: Every one likes low prices! If any company is able to offer its products/services at significantly lower price than its competitors due to operational efficiency or economies of scale, it will act as significant competitive advantage either in terms of higher market share (by keeping the prices low) or higher profit margin (by keeping the prices in line with competitors but generating higher margin). One such company is Hindustan Zinc. It is one of the world's lowest cost producer of zinc with average product cost of USD 800/ton compared to world average of USD 1200-1250/ton. HZL's low cost is result of exclusive mining rights to world class resource, fully integrated operations and high level of operational efficiency. It is very difficult to replicate combination of such advantages for most of the zinc producers and hence HZL is going to enjoy superior profitability with respect to its peers in years to come. Another well known example of lowest cost producer/economies of scale is Wal-Mart. Wal-Mart ,with its humongous size, purchasing power with the suppliers and fantastic supply chain network, is able to offer products at the lowest cost. Wal Mart's lowest cost advantage has trumped most of the competitors and has "pulled" consumers to their stores every day for more than 40 years!

Barriers to Switching: A business can create a sustainable competitive advantage by offering a product or service that has very high real/perceived cost of switching which will discourage customer/client to move to products offered by competitors. A typical example for moat built around high switching cost if Microsoft. It is extremely difficult to switch from Microsoft to Linux as it involves relearning of a new platform and supported applications. 


In Indian market, before mobile number portability came into effect, incumbent telecom companies such as Bharti, Vodafone and Reliance enjoyed this advantage as changing service provider keeping the same number was not possible which discouraged most of the customers from switching from one service provider to the other. Another place where I see perceived high switching cost is specialized components supplied for critical applications. Any supplier who has established track record for quality and performance for supplying such components used in critical applications is significantly insulated from competition as cost of failure of such component can be significantly high and hence customers will be very reluctant to switch to new product/supplier.

Organization Culture/Unique Business Model/Soft Moat: This one is the toughest to identify and yet in my opinion most durable as it is almost impossible to replicate such moat. Typically organizational cultures are nurtured initially by vision of some of the extra ordinary managers/executives. However over a period of time the culture becomes so ingrained in the organization that it becomes "inherent identity" of a company. Take an example of Southwest Airlines. It is one of the very few profitable airlines company in the world. South west has created unique combination of offering by adopting "fun-on the flight" and "value for money" as corner stone of their strategy. Southwest created a culture within organization that symbolized "love for fun" and "cost consciousness" and nurtured it by building incentives for employees to contribute towards these cornerstones. Even though many other airlines tried copying Southwest, none of them succeeded and wound up.

If I look at Indian market, Shriram Transport Finance Limited can be a good example of soft moat. STFL created a unique business model by offering commercial vehicle financing for pre-owned segment to single truck owners, a large but neglected section of truck operators. STFL, over a period of years not only mastered the art of risk management of perceived "high risk" borrowers, but created tremendous trust among this community. STFL is leveraging its brand identity, trust among truck operators and strong network to create another unique business model of "auto malls" where truck owners can trade trucks through organized auctions. It has also started offering services for refurbishment of old vehicles. Both these initiatives leverage company's existing "soft" advantage to the hilt (i.e. trust among truck owners, full understanding of psyche of truck owners). It is very difficult to create such synergy for any other CV financing company.This is similar to what Charlie Munger often describes as "weaving seamless web of trust". (for more analysis on STFL please click here)

For companies having durable moat, all these qualitative factors also translate into numbers. One can scan through P&L, balance sheet, cash flow statements and accounting ratios of various businesses and can easily filter out companies operating "commodity" business, but more on that in some other post. 


I would be glad to receive your views on other sources of moat for the company.