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Investment decision should not be based solely on numbers. Do not assume that an extremely profitable company will maintain its profitability in the future too. High growth companies often struggle to retain its profitability. The reason is very straightforward, success attracts competitions and the bigger the profits, the stronger the competition. If your highly profitable restaurant attracts huge footfall, then it is obvious that more returns will open in your vicinity. Sooner or later it will become difficult to maintain the same profitability. Therefore, highly profitable firms tend to become less profitable over the time as competitors eat away the market share.
Now let us have a look at how companies create an economic moat. The most common way is to offer a better product or service than its competitors. Customers do not hesitate to pay a little more for a better product or service. If you can charge a premium. Differentiating factors include features, technology, specification, durability, appearance or anything else. The problem is better technology or feature of any product is not sustainable over a long period. The reason is that competitors will always try to develop a superior technology or products. Further, it rewires enormous R&D expenses for developing superior products. As a result, the product will become more costly. The customer may become price sensitive. The current market leader may get replaced but its competitor due to the cost advantage. Take Nokia for example in the mobile headset sector, Nokia was the market leader from 1990 to 2010. Mobile handsets from Nokia were well known for their durability and quality. Gradually, Samsung started manufacturing an almost similar product at a lower cost. After that, with eh advent of Android operating system, Samsung overtook Nokia and emerged as a market leader. Apart from the real product differentiation, a strong brand name crates a perceived product differentiation in the customers’ mind. The product may not be superior to others, but customer will be ready to pay the premium for the brand name. Building a reputed brand is time consuming. However, successful brand sometimes act as a board economic moats. A common example is Apple Inc. apple chargers a hefty premium of tis iPhone and MacBook. Apple iPhone is 15% to 20% more costly than the most expensive Android based phone. However, there are no significant differences in functionality between the two. However, it is not necessary that all brands create a wide economic most. Take these popular airlines for example. Kingfisher and Jet Airways. The airline industry is structured in such a fashion that it is difficult to charge a premium just for the brand value. Customer lock in or enabling high switching costs is one of the best and durable competitive advantages. Brands, better products and cost advantages are relatively easy to spot from outside but knowing exactly what makes a customer lock in to a particular product or service to be difficult to find out.
Servicing cost refers to the factors that make it difficult for a customer to switch to the products or service of a competitor. The factors can be in terms of many, time or convenience, if the switching cost is high, then customer would not shift to the competitor’s product/service quickly. Thus, the company can easily demand a presume from its existing customers.
Facebook and WhatsApp are the perfect examples of the great economic moat without having any mandatorily switching cost. Apart from Facebook, there were dozens of social networking websites. Most of them were forced to close their operation. Internet giant, Google, was also forced t shout done their social networking site. It does not cost a penny to switch from Facebook, however, the networking effect prevents shifting. There are many free mobile chat applications. But all of my friends are already using WhatApp, so why would I switch to another communication platform? The resulting strong networking effect makes it very difficult to shift to another platform. Google, Facebook, What Sapp, Instragram, Twitter, LinkedIn, etc. are all prime examples of moat due to networking effect.
