The moat analogy is drawn from medieval times, when castles were surrounded by deep and wide pits filled with water and deadly crocodiles to prevent intrusion. Likewise, economic moats provide companies a competitive advantage, enabling them to earn high profits for long. Moats can also be compared with the competitive advantage or talent of cricket players like MS Dhoni, Virat Kohli or Sachin Tendulkar. Competitive advantage can originate from a number of factors, such as:
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Low-cost advantage: When a business offers a reliable product at lower costs, it acts as a strong moat. This also leads to an increase in the demand for the product. Take the case of Maruti Suzuki, which can produce economical and high-quality cars at lower prices. It helps the company command a significant market share.
Brand recall: It is the result of the premiumisation created by the company for its products in customers' minds. With it, the company carves a niche for its products and charges a premium.
For instance, Apple's iPhone sells like hot cakes, even though the company charges a huge premium for its product.
Distribution network: A wide geographical presence on the back of a well-knitted distribution network helps in increasing the demand for a product. A strong distribution network is a moat for companies like Hindustan Unilever and Asian Paints, enabling them to gain significant brand visibility.
Switching costs: High switching costs prevent customers from shifting to different products or brands. This is because of the physical effort and discomfort that he has to bear while switching to the product, apart from the monetary costs.
Patents: A company with valuable patents or technology creates a niche for itself. For instance, pharma companies enjoy a special exclusivity period to manufacture and sell a drug molecule. During that period, no other company can manufacture the same molecule. Hence, the company enjoys high profits because of no competition.
Products: Companies with popular products enjoy strong customer loyalty. Marico's coconut oil Parachute, for example, has a loyal customer base. Even though there are other coconut-oil manufacturers, still the brand enjoys market dominance. The same is true for Titan's Tanishq brand, which has a prominence in the organised jewellery market.
In today's dynamic world, companies may have temporary moats. For example, Bharti Airtel had a huge market share. But when its competitor Reliance Jio entered the market, both its moats and profits evaporated. An investor, therefore, should also study the sustainability of a moat.