If you need to blow your nose you use a Kleenex. You use a Q-Tip to clean your ears. If you have a headache you might take Tylenol. What do these examples have in common? Brand recognition. Brand recognition is how familiar a company’s brand is to consumers. This, along with other factors, helps some companies to form an economic moat. Economic moats serve as barriers to competition by creating a competitive advantage that is difficult for other companies to copy or replicate.
You can think about an economic moat by thinking about a castle with a moat around it. The bigger the moat is, the more difficult it is for intruders to attack the castle. Now, imagine that the castle is a company and their profits, the moat is the economic moat, and the intruders are other companies trying to gain a share of the company’s profits. The larger the economic moat, the more difficult it is for other companies to cut into their profits.
Economic moats take on many different forms and can be difficult to quantify (measure).
There are five types of economic moats: cost-advantage moats, intangible-assets moats, high-switching costs moats, size-advantage moats, and soft moats. Cost-advantage moats are when companies have a cost advantage and can squeeze out other competitors who try to enter their market. Intangible-asset moats are created when companies have some type of non-physical barriers that prevent other companies from competing; examples include patents, trademarks, and brand recognition. High-switching costs are just as they sound—it is expensive to switch from one company to another. Consider the swap from an Apple to Android phone. Not only does the user need to pay for a new phone to make the switch, they may also have other technology, such as a Mac or iPad, that would need to be adapted (either by purchasing new software or a different device) to achieve the same level of integration that iOS products offer. Size-advantage moats come from economies of scale, the idea that larger companies are able to do things better, faster, and cheaper (think $1 McChickens). Finally, soft moats are economic moats that are difficult to identify and describe. They could be caused by the unique culture of an organization or some other advantage a company has over competitors.
Investors should think about economic moats and consider them in their investment decisions. Companies with larger economic moats are more likely to protect their profits and therefore, your investment. Economic moats also allow companies to charge higher prices for their goods and services. For example, Kleenex brand tissues are more expensive than a dollar store brand.
What companies do you know have economic moats and brand recognition?
In this week’s video, Jun Min, professor of marketing in the Michigan Tech College of Business, illustrates what economic moats are and why they are important in business and in influencing the stock market.