After hearing from multiple people and being interested in business strategy, I read the 7 Powers by Hamilton Helmer. It describes 7 moats that can help companies achieve sustainable competitive advantage.
As Warren Buffet described:
“What we refer to as a “moat” is what other people might call competitive advantage . . . It’s something that differentiates the company from its nearest competitors — either in service or low cost or taste or some other perceived virtue that the product possesses in the mind of the consumer versus the next best alternative . . . There are various kinds of moats. All economic moats are either widening or narrowing — even though you can’t see it.”
Author refers to these moats as “powers” in the book. Below is a brief summary of these “powers”.
1. Economies of scale
A business generates economies of scale if per-unit cost decreases with increase in the output. When the production increases, the business can achieve cost efficiency and makes it difficult for competitors to beat their margin and lower price. Thus, once a company achieves economies of scale, it’s very difficult to compete with it and match the pricing without taking a hit on gross margin.
In this book, the author has provided an example of how Netflix gets benefitted from economies of scale. Other examples are Microsoft Azure and Amazon AWS. Software companies incur high costs for development, but they have a very low marginal cost. So, they get a huge scale advantage by selling it to more users and spreading their fixed costs over more number of users. In the logistics industry, the presence of a larger transportation network will reduce costs for companies that use these networks.
2. Network Effects
Network effect results when a product becomes more valuable as more people use it. Network effects are discussed very commonly in tech and the concept is widely used to conduct a strategic analysis of a tech company. I have discussed network effects in detail over here. Besides, here is a great article on how to measure network effects.
3. Counter-Positioning
Counter positioning is defined as developing a new, superior business model which incumbents does not mimic as it could damage their current business. Often, a challenger’s approach is novel and often unproven, and incumbent doesn’t want to hurt their hefty profit by investing in something that is unproven. Sometimes, the incumbents also have a view of how the world works and that could bias their judgment to invest in innovative technology or business model. Thus, counter positioning is considered as one of the toughest management challenges.
Helmer provides the example of Kodak. In the case of Kodak, both technology and business model innovation were into play. Digital photographs were not so good as traditional camera initially. Digital pictures had low quality and it didn’t serve Kodak’s primary customer segment i.e. photographs. Also, it was well outside their core competency. But, the real disruption came from inside. Kodak had a separate division to develop digital cameras, however selling their high margin camera was Kodak’s cash cow and the group leading that business unit gained political influence over the new business, which made it difficult for Kodak to innovate themselves.
4. Switching Cost:
Once a product or service is deeply embedded in your process or technology, it’s difficult to replace it without incurring high cost and change management. This type of moat is generally seen in enterprise tech. This is also known as vendor lock-in. Due to vendor lock-in, a company can even charge higher price and has no incentive in improving the product/service.
Helmer has provided an example of SAP. Once a customer starts using SAP products and integrates the products into their technology infrastructure and processes, it gets difficult to replace them without years-long effort. Also, once customers have an SAP shop, they lose leverage to negotiate price during upselling, cross-selling or renewals events.
5. Branding
Brand is one of the most difficult moats to achieve and it takes a long time to build it. Brands benefit from information advantage and social proof. Humans are influenced by what they see others do and approve. Brand is the strongest moat and it’s difficult to beat.
Charlie Munger mentioned about Wrigley’s brand as a strong moat in this article:
If I go to some remote place, I may see Wrigley chewing gum alongside Glotz’s chewing gum. Well, I know that Wrigley is a satisfactory product, whereas I don’t know anything about Glotz’s. So, if one is $.40 and the other is $.30, am I going to take something I don’t know and put it in my mouth — which is a pretty personal place, after all — for a lousy dime? So, in effect, Wrigley, simply by being so well-known, has advantages of scale — what you might call an informational advantage. Everyone is influenced by what others do and approve.
6. Cornered Resources
When a company gets preferential access to resources, they gain the power of cornered resources. The resources could be in the form of material, license, patent or talent.
Helmer provides an example of Pixar. Pixar produced uncommonly creative animated movies consistently due to an extraordinary team. They drove demand with attractive price & volume combination and were able to gain huge returns from box office. There are various other examples too e.g. access to a patent for a drug company, access/proximity to raw material for a manufacturing company etc.
7. Process Power
When an organization commits itself to a set of activities or a system which enables it to deliver superior and low-cost product/service, they can achieve process power.
Helmer gives an example of Toyota Production System (TPS). Toyota is known for its operational excellence. In 1984, GM established a joint venture with Toyota, called NUMMI. As a part of the joint venture, GM also sent workers to Toyota’s Japan plant. Toyota leadership was fully transparent in terms of their operational best-practices. Soon, in NUMMI plant also, they achieved the same operational efficiency which they had in Toyota’s Japan plant. GM conducted knowledge transfer and implemented this system in their plant. However, they failed to implement it and couldn’t get any benefit out of it. As evident from the example, a process isn’t just a set of procedures or activities. It’s an ecosystem and has to be deeply rooted in an organization and its culture. It’s difficult to replicate the process and can only be achieved by a long term of evolutionary advance.
Final Thoughts
Besides these 7 moats, in tech (especially for AI startups), people also talk about data moat. However, as mentioned in this article by a16z, treating data as a moat can mislead founders from focusing on the actual priorities.
Investors, entrepreneurs and business strategists should consider these moats as a mental checklist. It is also important to understand how big the moat is and keep widening that. Michael Mauboussin has provided a strategic framework to assess the magnitude of moat. The products or services that have durable and wide moats around them are the ones that create value to investors.
1If you’re interested in learning more about Moats, below are a couple of interesting articles from Tren Griffin.
