th-23Warren Buffet introduced this investing concept about a decade ago. When someone thinks of a moat, they typically picture a big water-filled ditch used to protect a castle. The wider the moat, the easier it is to protect the castle from invading armies. The narrower the moat, the more difficult it is to defend the castle. In investing, the concept of a moat is similar. A business can be thought of as an economic castle. The moat is whatever protects that economic castle from the “invaders.” The moat is the sources of competitive advantage that a firm has or can develop.

Researchers at Morningstar have studied the economic moats of corporations. They found that the share price of companies with the sturdiest moats has outpaced the S&P 500 by more than six percentage points a year over the past five years. Furthermore, the top 10% of the companies with the sturdiest moats have a sustainable competitive advantage for 20 years or more.

Economic moats can be a variety of things. Company brand is a powerful economic moat. Think of Coca-Cola and other top brands. These companies with huge brand equity have a wide economic moat. Another obvious economic moat is patents, licenses, and intellectual property. These economics moats effectively block competition. This is common in the pharmaceutical, medical devices, and technology industries. A third economic moat is the network effect. This is where value is created, and the moat is expanded as the number of users increase or more members join a community. Examples would be Facebook and LinkedIn.

So what does this have to do with pricing? Interestingly, according to Morningstar, low-cost producers in an industry have the least permanent moats. This is because someone is almost always ready to undercut their prices and margins. Across many industries, companies scramble to take costs out to compete with low-cost country competitors, disruptive competitors, or dumb competitors. Ironically, this all-out focus on taking costs out to compete on price often results in not investing in the new products, solutions, or business models that provide a wider and much more sustainable moat. It can be a death spiral for a company.

While innovation can be a longer-term solution, the company can often avoid this death spiral in the short-term by coming up with a clear offering structure to address the low-cost competitors. This means disentangling the offering (the offering could be the core product, services, and business terms) into its parts and understanding the relative customer value and cost to produce/serve for each of the parts.

The company can then use the various parts of the offering in combination to address different competitive situations. For example, when faced with a low-cost competitor, a premium manufacturer could unbundle the offering and provide only a core product with basic service. If the premium company has valuable technical support and services, it could charge for these separately. By varying the value of the offering with the price, the company at least has some chance to fight off the low-cost competitor and protect its moat.

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