Big Moat Business Part II

August 6, 2007 by Joe Ponzio

When a business changes your language, it likely has a good moat. Still, plenty of businesses have huge moats-and it is just a matter of understanding and uncovering them. Why do you need a moat? As Buffett says,

to protect you from the guy who is going to come along and offer [your product] for a penny cheaper.

A moat is a barrier to entry for competitors-a barrier that protects your owner earnings and helps ensure growth. Want to get in the lumber business? Chop down a tree and sell it to a lumberyard. So long as your price is cheaper and you can deliver on time, you are in business and your competitors are sweating…and slashing prices. In the end, their owner earnings will suffer. Of course, so will yours as the low-cost lumberjack.

Moats exist in thousands of businesses and industries-some we know, some we may never hear about (unless we’re looking).

The Beautiful Barrier

One of the best ways to assess a moat (or identify one) is to look for a competitors’ barrier to entry. What does it take-how much money and time-for someone to steal market share from your business?

Case in point-UPS and FedEx. How do you get in the shipping business? Convince someone to give you a package and the deliver it. Sound simple, until you have to get a 70 pound box across the country in 24-hours or you need 70 letters to go to 70 cities…right now. Can you get that done for under $13 a package?

Without a major upfront investment (in the billions), you won’t dent UPS or FedEx for decades.

The Finicky Consumer; or, Loyal Dollars

Though the barrier is important, you need to assess the customer as well. Don’t just look at what you would do, think rationally. Do people care if they send a package via UPS vs. FedEx? We tend to be creatures of habit; so, we often stick with what we know.

Personally, I ship with UPS. But, if I have a package that needs to go out, and I’m fresh out of UPS envelopes, I’ll head to Kinko’s and ship with FedEx. The UPS store is a block further, but I’d have to go through a light at a major intersection-both ways. I want my package to arrive on time. I know UPS and FedEx can do it. I know they are roughly priced the same. To me, saving four minutes by avoiding a light is worth using FedEx from time to time.

But hey-that’s me. The question is: Do other people do the same? Does FedEx or UPS have a large, loyal base? Or, will they both continue to profit and grow regardless of their customer base simply because there is such a huge barrier for competitors to enter the market?

Threat Of Substitutes; or, Moat Sharks

Still, competition will try and swim across your business’ moat. Does your business’ moat have sharks in it? The moat may be wide, but a billion dollars invested in a start-up competitor may give that company the economic advantage it needs to break into the market. What other barriers are hiding in your moat?

I trust my package with FedEx and UPS. In a super-big-no-other-option pinch, I may use the post office or DHL. I wouldn’t trust Bob’s Bait, Tackle, and Shipping-no matter how hard the hit the market.

Moat Muscle

What can the moat do for prices? If UPS and FedEx raise their shipping prices by a nickel, they make millions more. What can I do about it? Stop sending packages? Maybe they don’t want to charge me more. No problem-they can beat up their box and envelope suppliers a bit and increase profits.

What was that? You don’t want to accept our new pricing on your boxes? I’m sure your competitor down the street will give us twenty million boxes a year at our price. Good bye.

Moat business makes more money; no-moat business (box supplier) loses money.

As Buffett Says…

In his 1995 Letter To Shareholders, Buffett said:

In business, I look for economic castles protected by unbreachable “moats.”

What is unbreachable? A durable competitive advantage that will provide increasing owner earnings for many years.

A Note From Joe Ponzio

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