(FYI this was originally published as part of my newsletter — subscribe here https://www.antmurphy.me/)
We all want to maintain a competitive advantage long into the future but doing so becomes increasingly hard as competition grows and markets become saturated.
This is where ‘moats’ come in. You might have heard of them. Often attributed to Warren Buffett, who is believed to have coined the term ‘moat’.
A moat is the ability for a product or company to maintain a competitive advantage and fend off competition to maintain profitability into the future.
Moats are a key attribute that Buffett and the team at Berkshire Hathaway, arguably the most successful investment firm to have existed, look for when investing. It seems to have served them well so far.
There are 4 different types of Moats:
- 🔗 Network effects
- 💰 Switching Costs
- 🏦 Economies of Scale
- ❤️ Intangible Assets
That’s not to say that you need to have one of these moats, as you’ll see when we step through them that many brands will evolve and leverage multiple types of moats but having at least one moat will give you an edge when it comes to maintaining competitiveness.
Let’s dive into each one-by-one.
Have you ever listed a product for sale? How did you choose where to lists? Did you pick based on their scale and size?
Or perhaps you’ve purchased something because of its ecosystem? “I can use this at more locations…”
If so, there’s a high likelihood that you experienced network effects first-hand.
Network Effects are when your product becomes more valuable as the number of users (or nodes in your network) increases.
I mention ‘nodes’ in bracket because whilst network effects are usually based on the number of users it’s not always.
It’s about increasing your network to a size that is hard to compete with — for it to become a moat.
I’ll give you some examples.
Tesla’s charging network is a perfect example, the more chargers the move valuable Tesla’s cars become. Being able to leverage such a vast network of fast chargers has been a key selling point for Tesla’s especially in the early days, hence why they invested millions into the infrastructure.
Other examples of network effects are social media platforms. They’re not super valuable when it’s just you on the platform but as more and more the more valuable it is.
This then becomes a moat because building such a large network takes some time making it very hard for a competitor to come onto the scene and compete. This is one of the reasons why although there have been many other attempts (some more successful than others) to create social network alternatives, the giants of Facebook and Twitter have long outlasted them, whether we like it or not.
Last example I’ll give of a network effect would be marketplace type products.
Marketplaces are difficult for a number of reasons, notably having to manage a two-sided market (supply vs demand) however, marketplaces can leverage network effects. The bigger the user base, the more people there are to sell to, increasing the likelihood something would be sold, again increasing the motivation to list your product on there, meaning there are more products on the site, thus increasing the user base further — and so forth. This is also an example of a business flywheel.
From a strategy point of view, you may ask yourself if there is a way that my product or business becomes more valuable as users grow?
Communities, social media and marketplaces are perfect products for network effects but you can see with Tesla that it’s not isolated to those industries.
Ever considered switching to another product or company (perhaps another internet provider or something) and thought, “it’s not worth it”?
That’s likely switching costs in effect.
Switching costs are when the difficulty to move to a competitor increases overtime and eventually the benefits of switching become outweighed by the costs.
I’ll give you a few examples.
Apple’s ecosystem is a great example of swtiching costs. If you’re anything like me, over time you bought an Macbook and then an iPhone, you then set up your wallet with Apple Pay, begin using Keychain, then iCloud. Before you know it, you’ve also purchased a pair of Airpods and so on. The cost now to switch back to windows and andriod is very high. I will need to not only purchase the new devices but I will need to set up Google Pay and migrate all my files and passwords across from keychain and iCloud.
Sonos speakers are also another example. The more speakers you get and connect together the more valuable their product is to you (network effect) — however the more expensive switching becomes. You either need to replace them all at once or live with having two different systems and having to navigate between them.
Lastly it doesn’t always need to be a physical cost.
Loyalty programs, as an example, acheive switching costs through sunk costs.
A sunk costs is a cost that has already been incurred and cannot be recovered. In this case it would be your loyalty program points. It’s already been incurred once you decide to leave you wont be able to recover them, it’s a sunk cost.
The more points you accumulate the higher the sunk cost and the harder it becomes to switch.
Many loyalty programs do this in a clever way where as you spend points you still accumulate them. Thus never allowing your balance to be a 0 and therefore meaning you will always have sunk costs. More complex loyalty programs will also add on status tiers and other benefits further increasing the sunk cost associated with switching.
From a strategy point of view, you may ask yourself how might I increase the stickiness of my product? How might I increase the costs (whether physically or psychologically) of switching to a competitor?
Yep, you guessed it. Economies of scale are when the cost of production on a per-unit basis decreases overtime as the company expands.
This scale can get to the point where it becomes extremely hard for others to compete.
Consider that nearly 40% of all e-commerce sales in the United States are on Amazon. Now that’s near impossible to compete with.
Other examples of economies of scale are postal companies like FedEx and UPS. Their scale allows them to lower costs and be more competitive. Retailers like Wal-mart and Costco also leverage the economies of scale to lower their costs and provide greater convenience.
Economics of scale are often best suited for physical products like ecommerce and manufacturing. However of course it’s not isolated to them. However you don’t typically see economies of scale in services or software industries as services are typically not the most scalable products and software is the opposite, it’s inherently scalable meaning that there isn’t a huge impact to scale and costs when you have 1 users for 1,000.
Finally we have what is referred to as Intangible Assets.
An intangible asset is anything proprietary that is valued more than the alternatives. This could be technology, patents, trademarks, and/or branding.
Brands such as Apple and Ferrari are great examples of intangible assets. The brand itself is something that people flock towards and can demand a premium. People are willing to pay extra just to have the brand.
There are many cars better than a Ferrari technically — even base model Toyota’s have more physical features — but people will pay 100s of thousands for a Ferrari. They dream about owning the brand. That is a moat. Because Ferrari can produce significantly inferior cars and still sell them — of course, that might hurt them over time, but their brand fends off competition.
From a strategy point of view you might ask yourself, what assets might your product or company have that give you a competitive advantage against your competition?
Intangible assets aren’t just branding, they might be specific patents or trademarks. This is particularly true in spaces like manufacturing or pharmaceutical industries.
For those of you wondering where to start with defining a moat, here is an activity that I run as a workshop with clients to help define possible moats:
- STEP 1: Brainstorm 3 of your key competitors.
- STEP 2: For each, write down what makes your product offering different to theirs?
- STEP 3: Synthesise these into themes.
- STEP 4: Of the themes, which might be leveraged as a moat?
There’s no right or wrong when it comes to a moat and moats will change over time. — something that was once a moat might no longer be as technology, regulation and your competitors change.
It’s also worth stating that you don’t need to have a moat. It’s not mandatory from a product or company strategy point of view. Of course it’s nice to have and it will help but the vast majority of successful businesses don’t have a strong moat.