Moats Series 2: How resources, restrictions and customers can be the best possible moats

In our last offering in this series, we discussed how factors like scales of operations, process advantages and location of operations can prove to be effective moats. Now we move on to next important set of factors- rare resources, stringent entry norms and customer advantages. The first two prove to be quite formidable for new entrants. Existing players owing to an almost monopolistic position can take advantage of the situation keeping competition at bay and capitalising their own place in the industry. Customer advantage, on the other hand. is a very different ball game. It is created over a long period of time by offering consistent service and products thereby creating a great brand and becoming part of your customer’s lifestyle. Let us begin with the first one now.

Rare resources and Specialised Vendors

Not everyone has a mine of green diamond....!

Not everyone has a mine of green diamond....!

Some businesses are so new and specialised that not everyone can enter them. These companies are first to enter the new spheres and before anybody thinks of entering and competing, they would be highly specialised, learnt from experience and enjoying huge economies of scale. Not only this they would also be making a lot of money by innovating their monopolistic position.
We have to give example of Google here. Google is the largest search engine in the world, so large that 95% of us don’t even know of another search engine. Today they have diversified their revenue streams within this one vertical. They are earning on ads, tools, special e-mail services and enjoy a reputation that only one can dream of!
Another example that we must give here is that of AK Capital, a merchant banker who specialises in fixed income instruments like bonds. They are already ranked 12th in the fastest growing small companies in India and are among the three top players in debt market segment, according to a report in Prime Database. The service they render is truly one of its kind and the specialisation is particularly remarkable. If an investor thinks debt and bonds, AK Capital is what comes to mind first.

Stringent conditions and Interference

Would you dare to enter?

Would you dare to enter?

Following conditions make an industry difficult to enter and create an economic moat for the already existing players:
•    Heavily regulated industry: Alcohol sector is probably the biggest example of heavy regulations, rules and stringent operating norms in India. This is also a reason why there are very few Indian companies in the race here and those who have ventured here, usually end up changing ownerships every ones in a while. This is why when you talk of liquor industry in India, only global players like Diageo (Smirnoff, Johnnie Walker), Pernord Ricard (Bacardi) and Moet Hennessey figure! Even Mallya’s very successful and popular Kingfisher is now part of Diageo.
•    Government’s interference and monitoring: Again liquor is a great example here. Government and state machinery buys and distributes alcohol in most of the cases. This is especially true in Maharashtra, Delhi, UP, Karnataka, Andhra Pradesh etc. Dealing with government is not easy because you as an entity are much smaller than the government and thus never have an upper hand. Collections are tedious and delayed. Even withholding shipments owing to non-payment of previous dues is not allowed once documents have been issued.

Another example of the above two points is Reliance’s ambitious KG-D6 deal better known as Godavari basin deal. Now even though government opened exploration of gas and hydrocarbons for private players way back in 1991 but it regulates and monitors it very closely. With every private playe, the government enters into a production sharing contract and the ownership of gas reserves remains with the government. This arrangement went into trouble firstly because the two scions of the Reliance industries split and secondly, the Supreme Court ruled against them when they tried to claim ownership. The issue with supply and rate fixation has since then complicated the entire issue and the biggest reserve of gas in India remains underutilised. This has definitely set an example and as we discussed how expensive it is to explore and extract natural gas, this sector definitely has its economic moats.

•    Barred Entry: Government sometimes, keeping public’s interest and welfare in mind tends to close certain sectors from private participation. Indian Railways is one big example where no other player is allowed entry.

Customer Advantage

Customer is King and for good reason

Customer is King and for good reason

When it comes to business, customer is God and therefore their preference over a certain product over others creates a viable economic moat. But again customer loyalty can be fickle so only certain specific conditions can result in an actual moat.
1.    Habit forming offerings
A habit is part of routine and person so if a product can attain this kind of importance then there is a definite customer advantage and moat. Let us take the example of Microsoft which has a 90% share in operating systems market which means 90% of all laptops and have MS windows installed in them. Furthermore, over 90% of users are so used to Microsoft suite especially Word and Excel that using any other system is not only a difficult proposition but also a great deal of hassle. There is no doubt that a simple habit of using MS products have led doom of other good operating systems like Linux, Fedora, Ubuntu etc who would have done well if Microsoft was not in the picture.

2.    The Brand power
Brand is a powerful thing and this is why world over, companies, particularly in the FMCG sector are spending millions to create one. In India, Colgate has to be one of the most powerful brands and it is synonymous to toothpaste in over 55% households. 55% market share is super impressive considering there are so many oral health products but overtaking Colgate has eluded everyone till now. In fact, Sensodyne branded itself for sensitivity oral products and it popularised the concept of using special products for sensitivity. Sensodyne created awareness and then Colgate came with its own set of sensitivity products in no time and did really well overtaking every competition. This is brand power - where customer is always ready to come back to your products.

3.    High Switching Costs
This factor can be a big deterrent for a customer or client to switch from an existing vendor to another. Following conditions lead to these high switching costs.

a.    Contractual commitment
If there is an enforceable contract for a certain number of years then pre-closing it to shift to a different vendor can prove really costly. One can take a recent case of GMR as an example. GMR was under contract to run Maldives Ibrahim Nasir International Airport (INIA) but the government terminated this contract prematurely. When the case was referred to International tribunal, it ruled in favour of GMR. Now Maldivian government has to pay USD 250 Million to GMR for scrapping the agreement.

b.    Onerous process to switch
Sometimes a long, tedious and complicated process of switching to the new system or adopting new technology can be a big barrier. The classic example of this is changing accounting platform where the switch is not only costly but also takes a long time to come in effect. Many small software accounting packages in India are thriving because the businesses are not ready for a change. Tally has been the top software company in India for past two decades and a giant like SAP has found it difficult to penetrate the industry where companies are smaller and do not have overseas presence even though SAP is far more professional and reliable.

c.    Information privacy, databases and protection
In the process of working in partnerships like outsourcing or engaging a service provider, a number of confidential information and data is shared. Such information could pertain to proprietary processes, sensitive areas of business, new innovations that are underway etc. Though such engagements are governed by confidentiality agreements but we all know how rampant leaking information is in business circles. We have seen companies going at war on patents of similar technology. Such vulnerabilities increase when you switch from one vendor to another. The thing is, once the information leaks, it is difficult to go back and trace its source. It could be your vendor or even that disgruntled employee, the fact is, it is dangerous for you.
So these were the moats that really do matter when it comes to making your investment in a company who has long term viability against its competitors. Now that we have discussed various conditions that give rise to economic moats, wait for our next article where we discuss how to measure moats so that they help you take those critical investment decisions!