Types of Economic Moats

Low Cost Producer. Companies that can deliver their goods and services at a low cost, typically due to economies of scale, have a distinct competitive advantage because they can undercut their rivals on price.

Wal-Mart is a great example of a low cost producer, and its low cost allows it to price its products the most atractively. As a dominant player in retailing, the company's size provides it with enormous scale efficencies, or operating leverage, that it uses to keep costs low. This allows Wal-Mart to do its own purchasing more efficiently since it has roughly 5,000 stores world wide and it gives the company tremendous bargaing power with its suppliers. Since the company positions itself as a low cost retailer, it want to ensure that it gives the lowest price to its customers. This can result to tought bargaining terms for suppliers that want their products on Wal-Mart's shelves. As a result, Wal-Mart has prices that others have a difficult time of matching.

High Swithing Cost. Switching cost are one time costs that a customer incurs when switching from one product or service to another product or service. Companies aim to create high "switching costs" in order to lock in customers. The more customers are locked in, the more likely a company can pass along added costs to them without risking losing them to competitors.

The Network Effect. The network effect is one of the most powerful competitive advantages, and is one of the most easiest to spot. The network affect occurs when the avalue of a good or service increases for new and existing users as more people use the product or service.

Intangible Assets. Some companies have a competitive advantage over competitors because of unique nonphysical or intangible assets. Intangibles are things such as intellectual propety rights, government approvals, brand names, a unique company culture, or a geographical advantage.

It is possible for one company to have more than one kind of economic moat. For example, many companies that use the network effect also benefit from the economies of scale, because these companies tend to grow so large that the dwarf their competitors. The more types of economic moats that a company has the better.

The Financial Reality

Successful long term investing involves more than just identifying solid businesses, or finding businesses that are growing rapidly, or finding cheap stocks. Successful investing also involves evaluating a business and determining whether or not it can stand the test of time.

Moats are a useful framework to help answer that question. Identifying a moat will take more effort than looking up a few numbers, but understanding a company's long term competitive position is an important process in determining a company's long term profitability. And as we stated earlier, how well a company's stock performs is directly related to the profits the firm can generate over the long haul.

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