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Building an Economic Moat
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Next, we need to determine "why a firm has done such a great job of holding on to its profits and keeping the competition at arm's length. Although being in an attractive industry can certainly help, the strategy pursued at the company level is even more important. The mere fact that there are excellent companies in fundamentally unattractive industries (e.g., Southwest Airlines) tells us intuitively that this must be the case. Academic research suggests that a firm's strategy is roughly twice as important as a firm's industry "when it's trying to build an economic moat.

When you're examining the sources of a firm's economic moat, the key thing is to never stop asking, "Why?" Why aren't competitors stealing the firm's customers? Why can't a competitor charge a lower price for a similar product or service? Why do customers accept annual price increases?

When possible, look at the situation from the customer's perspective. What value does the product or service bring to the customer? How does it help them run their own business better? Why do they use one firm's product or service instead of a competitor's? If you can answer these questions, odds are good that you'll have found the source of the company's economic moat.

In general, there are five ways that an individual firm can build sustainable competitive advantage:

•  Creating real product differentiation through superior technology or
features

•  Creating perceived product differentiation through a trusted brand or
reputation

•  Driving costs down and offering a similar product or service at a lower
price

•  Locking in customers by creating high switching costs

J. Locking out competitors by creating high barriers to entry or high barriers to success

Real Product Differentiation

This is certainly the most obvious type of economic moat—after all, wouldn't customers always pay more for a better product or service? Unfortunately, simply having better technology or more features is usually not a sustainable strategy because there are always competitors hoping to build a better mousetrap. And because having the best product or service usually means charging a premium price, firms pursuing this strategy often limit the size of their potential market. Many customers will be satisfied with a slightly inferior product at a significantly lower price.

"Anita McGahan and Michael E. Porter, "How Much Does Industry Matter, Really?" Sti Management Journal, 18, p. 15 (1997).

More important, it's just plain difficult to constantly stay one step ahead of competitors by adding features or improving a product, which is why few firms are able to use this strategy to create long-term excess profits. This is especially the case in many parts of the technology sector and in the consumer electronics industry—today's vendor of the latest and greatest server, storage system, or DVD player is likely not going to be tomorrow's leading player. Finally, constant innovation generally sucks up a large amount of capital in the form of research and development expenses, which can make a product-differentiation strategy very expensive.

Data-storage manufacturer EMC is a good example. In the mid-1990s, the firm had leapfrogged IBM in this fast-growing area of the technology sector and was winning new customers because its products had features that IBM's lacked. For several years, EMC raked in enormous profits by charging customers substantially higher prices than the competition for its technolog­ically superior products. (In fact, EMC's prices were so high that customers nicknamed the firm "excess margin corporation.")

However, IBM and other competitors didn't give up. Eventually, IBM rolled out products that came pretty close to matching EMC's, and IBM priced them much lower in an effort to win customers back. As a result, IBM began regaining market share, and EMC's business suffered.

The lesson here is that although firms can occasionally generate enormous excess profits—and enormous stock returns—by staying one step ahead of the technological curve, these profits are usually short-lived. Unless you are familiar enough "with the inner workings of an industry to know when a firm's products are being supplanted by better ones, be wary of firms that rely solely on innovation to sustain their competitive advantage.

Perceived Product Differentiation

Very often, however, a firm with consistently better products or services creates a brand for itself, and a strong brand can constitute a very wide economic moat. The "wonderful thing about a brand is that as long as customers perceive your product or service as better than everyone else's, it makes relatively little difference whether it actually is different.

Tiffany is a fabulous example of the power of a brand to create excess economic returns. The simple fact that a piece of jewelry is packaged inside the famous little blue box allows Tiffany to charge a significant premium for its products. This example is fascinating because jewelry has so many objective standards—karats of gold, clarity of diamonds—that measure the quality of an individual piece. The fact that consumers will pay more for a virtually identical diamond ring from Tiffany than from a local jeweler is what defines a truly valuable brand: It increases a consumer's willingness to pay.

Thinking about brands and reputations in this way—whether consumers of a product or service are truly willing to pay more to buy the good from one firm instead of another—helps separate more valuable brands from less valuable ones. What matters is not the existence of the brand, but rather how the brand is used to create excess profits. In fact, brands aren't useful at all in some industries.

Think about companies such as Sony or Ford, both of which have well-known brands. But both firms have struggled to generate solid returns on capital over the past few years because they sell goods that are simply not very amenable to brand-driven price differentiation. Consumers are unlikely to pay much more for a Sony stereo relative to a product from Panasonic with similar features, and they're also unlikely to pay more for a Ford truck j ust because it has the Ford nameplate.

On the flip side, Abercrombie & Fitch has managed to convince legions of teenagers to pay $25 for aT-shirt just because it has "Abercrombie" on the front. How long this brand will remain strong is tough to predict, but there's no question that it's enabled Abercrombie to charge more for its products over the past several years. In fact, the durability of a brand is a critical component of any brand-based economic moat. Some brands— for example, Coke or Disney—last for generations, but some are much more fleeting.

When you're evaluating whether a strong brand really does create an economic moat, it's not enough to look at whether consumers trust the product or have an emotional connection to the brand. The brand has to justify the cost of creating it by actually making money for the firm, and sustaining a powerful brand usually requires a lot of expensive advertising. Therefore, unless the brand actually increases consumers' willingness to pay and those looser wallets translate Into consistently positive returns on capital, the brand may not be "worth as much as you'd thought.

Driving Costs Down

Offering a similar product or service at a lower cost can be an extremely powerful source of competitive advantage. It costs Southwest 25 percent less to fly one passenger one mile than the leanest of the major airlines, and it's that ad­vantage that propelled the firm from a Texas upstart to a big-league player in 25 years. Low costs have fattened Dell's profit margins to such an extent that the firm has been able to expand its share of the PC market from around 6 percent in 1997 to more than 15 percent by year-end 2OO2—a big move in j ust six years.

Airlines and PCs are known as commodity industries, in which products are tough to differentiate. Low-cost strategies work especially well in these types of markets. Even in noncommodity markets, lower costs can bring large advantages as long as the cost advantage is sustainable and not temporary. However, it's not enough to just look at a firm's profit margins and say that such-and-such firm has lower costs than its competitors—you need to identify the sources of those cost savings, which can come in a variety of flavors.

In general, firms can create cost advantages by either inventing a better process or achieving a larger scale. Dell is the classic example of a firm with a process-based advantage. Building PCs only after they're ordered allows the firm to take advantage of the swift price erosion of PC components—parts don't sit in inventory losing value while the firm waits for orders to come In. Over time, Dell has continued to squeeze costs from its supply chain to the point where you could argue that Dell is no longer a technology firm, but rather a manufacturing one.

Process advantages can also be subtler. In the asset-management industry, you might think that Vanguard's size is what allows it to underprice its ser­vices—but there are other firms of comparable size with much higher fees. The key is that Vanguard is structured as a mutual organization that's collectively owned by fundholders, rather than a profit-maximizing corporation owned by shareholders. Because of this structure, Vanguard can plow back excess profits into cost-reducing activities, whereas traditionally structured asset management firms will either distribute excess profits to their managers in the form of fat bonuses or allow the cash to pile up on the balance sheet. In Vanguard's case, higher profits allow the firm to push costs down, which at­tracts more assets, which generates more profits, and so forth. This relatively unique structure means that it will likely be very difficult for any non-mutual asset-management firm to ever match Vanguard's low costs.

Scale advantages are often very difficult for competitors to match because they tend to build on themselves: The largest firms continue to drive down costs and prices, and smaller ones have an increasingly difficult time catching up. The most basic form of a scale advantage comes from simply leveraging fixed costs—in other words, spreading the cost of an asset such as a factory across an ever-larger sales base. Intel, for example, produces far more microprocessors in any given year than archrival AMD, which means its per-chip production cost is a great deal lower than AMD's.

Fixed costs don't have to be factories. For example, the trucks that make up the distribution network of package-delivery service UPS represent an enormous fixed cost that allows the firm to deliver to more locations at a lower cost than almost any other competitor. Although replicating a delivery network that serves only large metropolitan centers might not be too daunting a task for a potential competitor, replicating a network that can deliver to virtually any address in the United States would be another thing altogether. Because it costs UPS very little extra money to put an additional couple of packages on a truck that's already serving a particular delivery route, its profit on those extra couple of packages is high.

Locking In Customers

Customer lock-in, or creating high customer switching costs, is possibly the subtlest type of competitive advantage. Uncovering it requires a deep understanding of a firm's operations. Cost advantages, brands, and better products are all relatively easy to spot from the outside, but knowing exactly what makes k tough for a customer to switch from one firm to another can be difficult to find out. However, it can also be very powerful, which is why firms with high customer switching costs often have wide economic moats.

If you can make it difficult—in terms of either money or time—for a customer to switch to a competing product, you can charge your customers more and make more money—simple in theory, but difficult in practice.

Remember, a switching cost does not have to be monetary—in fact, it rarely is. Much more frequently, what deters customers from dropping a product or service in favor of a competing product or service is time. Often, learning how to use a product or service can require a significant investment of time, which means the benefits of a competing product have to be very large to induce a switch. A consumer might switch brands of tomato sauce because one tastes just a little better than the other, but a "word-processing program would have to carry huge advantages over an incumbent program to induce a consumer to throw away the accumulated knowledge and spend time learning the new program.

Medical device firms such as Stryker and Zimmer are perfect examples of how firms can create high switching costs that help ensure customer retention. Both of these firms manufacture artificial joints such as hips and knees, and surgeons have to be trained on how to implant their products—a Stryker hip is different enough from a Zimmer hip that a surgeon can't just choose one or the other based on which is on sale that week. This training process is time-consuming for surgeons, "which means surgeons tend to develop preferences for a particular company's products and stick with them. Therefore, Stryker, Zimmer, and their competitors tend to have relatively stable shares of the joint-replacement market—a firm would have to introduce a measurably better product to induce surgeons to incur the retraining costs needed to use the new product.

When you're looking for evidence of high customer switching costs, these questions should help:

•  Does the firm's product require a significant amount of client training? If
so, customers will be reluctant to switch and incur lost productivity dur­
ing the training period.

•  Is the firm's product or service tightly integrated into customers' busi­
nesses? Firms don't change vendors of mission-critical products often be­
cause the costs of a botched switch may far outweigh the benefits of using
the new product or service.

•  Is the firm's product or service an industry standard? Customers may feel
pressure from their own clients—or their peers—to continue using a
well-known and well-respected product or service.

•  Is the benefit to be gained from switching small relative to the cost of
switching? Bank customers, for example, often endure slightly higher fees
because the lower fees they might get from moving to a competing bank
are of less value than the potential hassle of moving their account.

•  Does the firm tend to sign long-term contracts with clients? This is often
a sign that the client does not want to frequently switch vendors.

Locking Out Competitors

Locking out competitors is the fifth strategy that firms can use to generate lasting competitive advantages. If done well, this can result in years of strong profits. If done too well, it can invite the scrutiny of the federal government on antitrust grounds—as Microsoft (and other firms) have discovered.

The most obvious way to lock out competitors is to acquire some kind of regulatory exclusivity, as many casinos do from state governments. Li­ censes and such are powerful deterrents to competitors—but because gov­ernments make the rules, they can also change them without warning. U.S. state governments have been known to raise the tax rates on the casinos they license after the casino facilities are in place and generating profits. Although the casinos "were still protected from competitors, state governments were able to tax away a larger portion of their excess profits than the casinos ini­ tially expected.

Patents fall into the regulatory category as well because a patent holder is legally protected from direct competition for a set period of time. And as large pharmaceutical companies have demonstrated, patents can lead to years of extremely high profit margins. But although patents may deter competi­ tion, they tend to attract litigation, which can severely hamper the patentholder's ability to earn excess returns.

A great example is Pfizer, which holds patents on some of the top-selling drugs In the world. These patents allow the company to charge high prices for new drugs for years after they hit the market. Competition during the life of the patent is usually limited, so profits and cash flows are huge. That's one reason Pflzer's average return on equity over the past decade has been greater than 30 percent and its net profit margins are currently north of 25 percent (compared with around 6 percent for the average S&P 500 company). That's also why it's been a great stock to own over the long haul. In fact, many of the major pharmaceutical players have outperformed the market over the past IO years because of the economic moats inherent in this industry.

However, although patents and licenses can do a great job of keeping competitors at bay and maintaining high profit margins, they can also be ephemeral. If you're investigating a firm whose economic moat depends solely on a single patent or other regulatory approval, don't forget to investigate the likelihood of that approval disappearing unexpectedly. This will likely involve a detailed reading of the legal proceedings section of the firm's IO-K filing. (You can find financial filings through most firms' Web sites, as well as di­ rectly from the SEC's Web site.)

A much more durable strategy for locking out competitors is to take ad­ vantage of the network effect, A strong network becomes more valuable as the number of users increases—much like a telephone network, which wouldn't be "worth much if you could call only a dozen people, but which has immense value given the enormous number of users. Companies that have a network protecting their competitive positions often have very wide economic moats.

In general, markets tend to have strong network effects—the more buyers and sellers that transact in a particular market, the greater the value of that market to participants. As a publicly listed auction market, eBay is the purest example of this idea: The firm has held its own against much larger com­ panies, and it seems unlikely that another competitor will emerge soon.

It should be easy to see why eBay has a near-monopoly in online auctions in most of the world. Because eBay was the first major firm to connect indi­ vidual buyers and sellers over the Internet In an auction format, the number of buyers and sellers grew very quickly. As more rare baseball cards and vin­tage posters came up for auction on eBay, more buyers "were attracted to the site to bid on those items. Those extra bidders attracted still more sellers— the sellers "wanted to go where the buyers were, and the buyers wanted to go "where the sellers were.

By the time competitors such as Yahoo! and Amazon.com tried to get into the auction game, it was too late. There were already too many bidders on eBay for sellers to want to switch to a new, smaller auction service—they'd probably get a lower price for their wares because there "were fewer bidders on each item. Meanwhile, the bidders weren't interested in going anywhere either because eBay had by far the most items for sale. Thus, eBay gained crit­ ical mass and, today, a near-monopoly position in the online-auction market. Another great example is money-transfer concern Western Union , which is owned by First Data. With more than 170,000 locations "worldwide, odds are pretty good that Western Union can get your money "wherever you need it to go, and the value of the firm's agent network only grows larger as it adds locations. The central characteristic of a classic network effect is a virtuous circle—more users attract more users.

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