What does a moat look like?
“The most important thing [is] trying to find a business with a wide and long-lasting moat around it … protecting a terrific economic castle with an honest lord in charge of the castle,” Buffett said in the now fabled and legendary Berkshire Hathaway annual shareholder meeting in 1995.
Moat — a strategic edge, a competitive advantage that is long lasting and has a compounding effect upon the success of the company in the market.
I wanted to outline what are some key characteristics of a company or a business model that have a great moat working for them. And this is a foundational trifecta.
A business has a great moat if:
- It does a very small, but very critical part of a very large process
- Their product or service has a very high switching cost
- They have the right pricing strategy
- Doing a very small, but critical part of a very large process
The global market for yogurt consumption is estimated to be at about $85.56 billion. What do people latch on to in this product? The taste. While running a decentralized, global value chain, dairy companies maintain their recipes and formulas to ensure product consistency in taste, texture and everything in between. And the single biggest deciding factor for that is the kind of bacteria the company uses to convert milk into yogurt.
Enter Christian Hansen, a global bio-science company based in Hørsholm, Denmark that develops natural solutions for the food, beverage, nutritional, pharmaceutical and agricultural industries. A company that actually creates and evolves bacteria to supply to these dairy FMCG companies, thereby controlling a very public and highly identifiable characteristic of the product.
That service is a small, but critical part (yogurt bacteria) of some very large process (dairy FMCG retail).
2. High switching cost
Working with the same example, we can see how their nature of business and Intellectual Property lends itself easily to also enable a high switching cost. Customers prefer certain yogurt brands over others because of its taste, texture and shelf life. By providing certain flavors of bacteria and evolving them genetically, Chr. Hansen also creates a sufficiently high exit barrier for its clients by ensuring better quality yogurt, and locking their customers in through the taste.
This creates a high switching cost for their clients.
Another sphere of the world where this happens is within Formula 1. In a world where there are just 20 superhumans who get to drive hyper-engineered cars which are optimized for tight cornering, downforce, straightaway speeds, and safety — most each component is built to specification. Teams would often spend up to half a billion dollars to win a championship. Since each car and driver is at the absolute limit of human capabilities, there are merely tenths of a second between each of them. Which is what makes the sport so high stakes, exhilarating, and costly. Parts such as carbon fibre chassis, front wings, rear wing, side pods could cost you a cool half-million all the way to a few million, while the most expensive of them has to be the engine unit — which would put you behind just shy of 10–15 million.
Now to make things interesting, there are only true blue constructors who are approved to (OR even can) build engines — Ferrari, Mercedes, Renault, and Honda.
And then to make things even more interesting, you have changing engine regulations (2022 season marks the beginning of a new era, after the turbo-hybrid era which was absolutely dominated by Merc). So here you have a lot of supplier and buyer pricing games that can be played. Changing engines could be costly, or could work out — but the switching costs are undeniably there.
An example of a very strong moat can be seen in the case of the Mercedes AMG team where because of their dominant engine, many teams flocked to them as their core supplier from 2014–2021. They possessed a lot of power in the business since not only were they winning races due to their car and driver team, but also dictated the terms and prices for their engine and enjoyed revenue because of their success on the track. This means more marketing eyeballs for their sponsors, meaning more funds to invest in next year’s car. And the virtuous cycle continues.
3. Pricing Strategy
The last piece of the trifecta becomes a sensible pricing strategy that needs to work to enable a competitive advantage for the business. At its core a way to evaluate this would be to charge in relation to the value of the overall process that your product/service is catering to, instead of just the component. That might also allow you to think of dynamic pricing across seasons/business cycles. Canadians would buy shoes all year round, but for different purposes. So discounting snowshoes in the middle of July might help move a dead inventory while pricing them higher in Christmas might help you hold on to a fast depleting inventory and enjoy the supplier leverage by procrastinating buyers.
Overlaying some key questions across the traditional Porter’s five forces model might help us think through the key pricing threats for your business and what could be some stem questions that could help you maneuver and fit pricing.
Apart from Industry rivalry & price undercutting— which is inevitable unless you have an unbelievable scale resulting in lower operating cost — each factor here on a high level here can be mitigated in a theoretical sense. A key point to remember here is that these would need to be added on top of your break-even. However, there could be cases where you would price in a way that you operate at a loss for a few years before you make money. A typical case study is growth companies like Uber — which started turning a profit a few years post IPO.
If you enjoyed this, you would also love some other essays I have written. Check out ‘Honey Acquisition: PayPal’s Systemic Chess Move’, ‘Hypothesis Creation: A consulting super-skill’ and ‘How to start playing with Agile’. Follow me on @Slim_Snail for everything Marketing, Brand Strategy, Consulting and Strategy. Also, request you all to like and share it with your friends and colleagues. Thanks! :)
