An economic moat is one of the main ways I evaluate a particular firm. Using this mechanism, one can look further into the underlying fundamentals, often providing essential insight essential to any investment. Below are 7 signs of an apparent durable competitive advantage, along with examples of companies with those advantages in their favor.
1. Competitors have filed an antitrust lawsuit.
AT&T (NYSE:T) is a classic example of this type of moat, where regulators forced the company to divest its local telephone business into the form of seven different "baby bells." This sparked heavy competition for AT&T's long distance segment, unfortunately diluting its moat. Google (NASDAQ:GOOG) is another excellent example, in that it has lately become a target of its competitors, but the company's argument that "the competition is just a click away" has kept Google's core search business out of trouble so far.
2. There is incredibly low customer satisfaction, but retention is high.
Although companies such as Apple (NASDAQ:AAPL) or Amazon (NASDAQ:AMZN) can provide great customer experiences which can allow them to gain businesses of scale, when customers want to leave but can't it is generally a sign of a strong moat via large consumer switching costs and or the network effect. A great example that comes to mind here is Facebook (NASDAQ:FB). Its revenue stream is primarily generated through advertisements, which most people I know hate. Nevertheless due to how it has nearly 1 billion + users, there really isn't anywhere else to go.
3. Large amounts of sales come from aftermarket products or services.
This type of situation is typically a signal that a company is benefiting from high switching costs, primarily due to a customer making a large up front investment that they don't want to lose. A great example of this is United Technologies (NYSE:UTX), which has massive switching costs after an Otis elevator or other unit has been installed. This has allowed for a juicy margin service revenue, and will continue to be the case for years to come.
4. The industry has slow product cycles.
Typically, companies with slow product cycles are in a much better competitive position than those with fast ones. In industries where products don't change much, such as beverages, with Coca Cola (NYSE:KO) being an excellent example, companies have already established the basic framework of a core business, and have no real need to take a big risk for their needs. On the other hand, companies with fast product cycles such as most tech giants suffer from rapid price deflation. The playing field is always changing, so capitally intensive companies like Intel (NASDAQ:INTC) Dell (DELL) and Nokia (NYSE:NOK) must constantly spend billions of dollars on research and development just to maintain their moats.
5. Within the industry, rivalry is low and or there is a high concentration of firms.
The level of competition in an area will be a prominent factor in how profitable a company will be over a long period of time. A large worry in the blue-chip tech stocks right now is who will be the ultimate winner in the Apple, Google and Microsoft (NASDAQ:MSFT) showdown right now. Each must be able to maintain high returns on capital over a long period of time. Digressively, inside industries with little competition will need a lesser defense in order to maintain their durable competitive advantage.
6. A cartel is present.
Cartels are situations where competitors band together in some way to manipulate output pricing of a particular good or asset. This allows for increased profits within an industry. Having an industry with a cartel also helps limit a bearish scenario in cases such as those of commodities. Companies that come to mind here are Exxon Mobil (NYSE:XOM) and Potash Corp Saskatchewan (NYSE:POT), which have industries that are generally manipulated by this effect.
7. Company profits are a small portion of customer budgets.
A situation such as this one is generally one that will indeed expand a moat, but isn't strong enough to entirely form one by itself. It also allows for a stronger building of a brand name for an individual company. Take Fastenal (NASDAQ:FAST) for example, as their profit margins have seen astronomical levels due to only spending $0.50 on high quality widgets. The sign also applies to consumer staples companies as well. One might think long and hard for spending several hundred dollars on a new television as opposed to spending a dollar or two on say Wrigley's chewing gum or a can of Pepsi (NYSE:PEP).
These methods for evaluating a firm don't necessarily guarantee that a business has a small or large durable competitive advantage, and they surely don't mean that a particular firm is attractively priced for a large return. However, they do indicate specific hints that any investor can use to get an idea about a particular stock or whether a company is worth taking a deeper look at. On the matter, companies with several elements of these types of moats that are modestly priced at current levels include Coca Cola, Apple and Potash Corp Saskatchewan. Investors should also keep in mind that a moat helps drive a stock over a long-term horizon, not simply a year or two. It essentially gives a company that factor to oust competitors in its industry.
Disclosure: I am long KO, AAPL, GOOG, MSFT, XOM, PEP, FAST. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The other companies mentioned positively also have the capability to become great investments, they simply need a pullback in their stock price. Credit to Morningstar for discussing these sources of economic moats.