A dispute between Tesco and Unilever over the price of Marmite hit the headlines this week. Unilever demanded that Tesco pay more for its products including the popular yeast extract claiming that the weaker pound has pushed up its costs. Tesco refused. The two have since reached a deal, but the outcry over the prospect of Marmite-free supermarket shelves shows the importance of a key concept in investment the "economic moat".
US investor Warren Buffett argues that an economic moat is one of the main factors an investor should look for when choosing long-term investments. A moat protects a company from competition, allowing it to hang on to its market share and maintain its profit margins, rather than have them eroded away by rivals.
There are several types of moat. Size is one. Big firms enjoy economies of scale they can sell goods at lower prices than smaller rivals, and still make a profit. They can also use their market dominance to force suppliers and customers to accept the terms they're offered. Both Unilever and Tesco have been accused of wielding their market power in this way.
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Intangible assets such as popular brands also act as moats. Apple fans are notoriously willing to pay up for the Apple brand, even though similar, cheaper products from rivals are widely available. Other types of intangible assets include respected management or trade secrets (such as Coca-Cola's recipe) that allow a company to stay ahead of its rivals. A high cost of switching in terms of cash, complexity, or time from one provider to another can also insulate companies from competitive pressures.
Network effects where a product's market dominance protects its position work as moats too. The classic case was the triumph of VHS over Betamax in the "video wars" of the 1980s VHS won out because a wider selection of films were available for the format. Regulation is another type of moat.
Industries such as water, electricity and banking are so tightly regulated that it is hard for new entrants to challenge existing firms. Rules meant to cut down on the number of smokers have made the tobacco industry virtually immune to new competition. Patents, trademarks and copyright are similar barriers to entry.
Of course, some moats are more durable than others. Those based on regulation can be precarious as they tend to invite intervention. For example, the government is keen to make it easier for people to switch bank accounts and electricity suppliers. Even those based on brand loyalty or past performance eventually disappear, particularly as new technologies come along. However, in the short and medium terms a moat can help to ensure a steady stream of profits, and if a company lacks an obvious competitive advantage, it's worth asking yourself why you are investing in it at all.
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