The first section of any investment report is a company overview.  Here is where you capture, clearly and simply a brief snapshot of what that an investor should care about when investing in a company.  I should be able to look at in, and in a few quick minutes know exactly what a company does, where they make their money, and what their place in the overall market is.

Let’s use Disney as an example.

The first question: What does Disney do?  Well, if you ask my kids they make magic, they make princesses.  They create characters.  They operate theme parks.  They make movies.  And did you know they also own ESPN, the largest sports network in the world.  In fact, 60% of sales and

Ok, so we have two friends both opening a store. Our first friend, Jack, wants to open a chain of candy stores.  It costs him $2,000 to build a candy store, and each earns him $1,000 per year in profits. That’s a whopping 50% return on investment!  In two years he has made his money back. In four years doubled his money, assuming the stores stayed just as profitable.   Pretty incredible.

Now our other friend, Jill, wants to open a chain specialty pet stores called Just Rodents.  It costs the same $2,000 to build a store, but it’s a bad business, (who wants to own a pet rat?), and it makes only it $40 per year in profits, or a 2% return on investment.   The stores cost the same the build, one just makes more than the other.

So they both go to you and want you to invest and buy half the stores for $1,000 each. Do you invest in Jack’s Candy shop of Jill’s Rodent Shop?  Of course, the answer is obvious, you chose the higher return business.

A business that earns a high return on capital or return on equity is always the best business.  A 10% return on capital business is better than a 5% return on capital business, but not as good as a 20% return on capital business, and Jack’s 50% return on capital business is phenomenal.  But since everyone knows what the business is earning today, the real question is, can they keep earning those high returns years into the future?

There are a couple of laws. Like the law of gravity, Murphy’s Law and Under laws of economics, any time a business like a candy shop earns exceptionally high returns, forces will come in to reduce those returns.  If Jack’s candy shop is earning a 50% return on capital, like a magnet, this is going to attract a lot more people to open candy shops, charge lower prices, advertise more, and eventually those returns are going to come down.  This is economics 101 – if a company earns a return on capital above the average, competition is going to come in and compete it away. High returns on capital attract competitors like bees to honey.

Unless however, this company has something unusually powerful that others can’t imitate it. Warren Buffett called this an “economic moat”.  Like a medieval castle, some very good companies are protected by a wide moat to keep competitors at bay, and others aren’t, so high returns one year won’t mean high returns into the future.

The best companies are the ones that make high returns on capital, but are able to protect and grow those returns through a unique protection (moat) that makes it very difficult for those competitors at the gates to come in and take them away.

Warren Buffett and Charlie Munger always say there are four key aspects of a wonderful investment.

• It must fit within their circle of competence, meaning Buffett and Munger must be able to understand how the business earns money and be able to predict, with reasonable accuracy, how much the business will likely earn 10 years in the future
• The business must be run by able and honest management
• The business must be purchased at a fair price
• Finally, the business must possess a durable competitive advantage

What do we mean by durable competitive advantage?  We will illustrate elements which provide businesses with a durable competitive advantage through the example of a simple lemonade stand.  At a high level, a durable competitive advantage means there are characteristics the business possesses which allow it to earn above average profits.  This occurs primarily because there are elements (which we will discuss) that prevent ambitious competitors from stealing customers and profits from the business.

Let’s take the example of a lemonade stand.  Let’s say you set up a lemonade stand in front of your house.  You purchase lemons, sugar, ice, and water and make your own homemade lemonade.  You then rent a large table and put it up outside of your house every afternoon and wait for customers to purchase your refreshing lemonade.  This is a simple example of the power of business – you combine capital (the initial money you require to purchase the ingredients, table, and signage) with labor (your effort and skill to create the lemonade and sell it) to create a valuable product for your customers (cool, refreshing lemonade on a hot day).  In exchange, your customers purchase your lemonade at a price which covers the cost you incurred to make the lemonade plus an extra amount which you take as your profit.  Your profit represents the reward you get for providing your customers with a valuable product.

After a few weeks, however, your next door neighbor notices that you are making a lot of profit selling lemonade to people walking through the neighborhood.  Seeing an opportunity to earn money, your neighbor establishes a lemonade stand one hundred feet from yours.  Your neighbor is also quite good at making lemonade and creates an equally tasty product to sell to customers.  You soon find that half of your customers are purchasing lemonade from your neighbor.  In an attempt to woo back your customers, you lower the price of your lemonade.  However, your neighbor won’t easily give up.  She too lowers the price.  Soon, you and your neighbor enter into what business people call a “price war.”  You aggressively take turns lowering the price of the product until neither of you is making a profit on the sale of lemonade.  You both will be unwilling to reduce your price further because you reason that it’s not worth your effort to sell the lemonade at a loss.  In fact, it’s unsustainable.

This is an example of a perfectly competitive industry.  In perfectly competitive industries, ambitious competitors are easily able to set up a competing business and steal customers from existing providers (also known as “incumbents”).  In perfectly competitive industries, businesses earn very little profits or no profits at all.  In these industries, customers benefit the most because they usually are able to obtain a product or service at the cheapest possible price (think of the example of the lemonade stand).  Historically, perfectly competitive industries, with some exceptions, include airline carriers, restaurants, personal computers and related electronics, apparel, hotels, and the neighborhood lemonade stand.  Generally, consumers of these products and services have the ability to choose among a number of providers and typically will choose the lowest cost option.

What factors could give your lemonade stand a durable advantage, prevent your ambitious neighbor from setting up her own stand, and allow you to capture most of the profits available?  Let’s walk through some scenarios.

• Superior Product / Intellectual Property: Let’s say you developed a secret recipe which resulted in superior tasting lemonade. This recipe would require ingredients and a manufacturing process which could not be easily copied by your neighbor.  You could also protect your secret recipe from imitation by filing for a patent with the U.S. patent office.  A patent issued by the U.S. government grants the holder of the patent the exclusive right to a product or process (the invention) for a set period of time (typically 15 years).  In this case, if you owned a patent to your lemonade recipe, neither your neighbor nor anyone else would be able to copy your delicious recipe for lemonade.  If this were to occur, your customers would likely choose your lemonade versus your neighbor’s lemonade due to the superior taste.  You would be able to maintain high prices and earn outsized profits.  Meanwhile, your neighbor would find herself without customers and most likely be forced to close her stand or find a different neighborhood to serve.
  • In the business world, many businesses enjoy sustainable competitive advantages due to a concept called intellectual property. Intellectual property is an invention of a product or process that is either difficult to imitate or protected by a patent.  Coca-Cola’s classic Coke recipe and KFC’s fried chicken recipe have been kept secret for many decades.  No competitor has been able to replicate the flavor of either product.  Similarly, many pharmaceutical companies, for example Pfizer, hold valuable patents on the drug formulations they develop through internal research.  These patents allow Pfizer to sell critical medicines in the marketplace nearly free of competition.  These businesses all possess durable competitive advantages and are able to earn above average profits.
• Advantaged Access to Supply: Let’s say that you have an exclusive relationship with a local lemon grower which allows you to purchase lemons at a lower cost than anyone else in your neighborhood. This would give you a cost advantage versus your neighbor or anyone else who decided to set up a lemonade stand.  As discussed above, in a perfectly competitive industry, profits are competed away to the point where competitors can earn no profits at all.  But, what if you have a lower cost than anyone else.  You can then lower your price to the point where your competitors can no longer make a profit, but you can.  To illustrate with numbers, let’s say it costs you $1 to make a cup of lemonade.  Your competitors, by contrast, can’t make lemonade for less than $2 per cup because they don’t have access to the same lemon grower you do.  Your competitors would not be able to charge $2 per cup or less because there would be no incentive left to stay in business.  At $2 per cup, however, you can still earn $1 of profit.  This gives you a sustainable competitive advantage.
  • In the business world, many businesses enjoy competitive advantages due to advantaged access to supply. For example, the major oil fields in Saudi Arabia, due to their geological formation, provide easy access to abundant oil.  In fact, the state-owned Saudi Arabian oil company is able to produce a barrel of oil for $10 while it costs most other businesses $50-60 to produce a barrel of oil.  This has given Saudi Arabia a competitive advantage in the oil markets.  Similarly, many Silicon Valley startups benefit from advantaged access to labor and capital.  The key input for a technology startup is access to skilled employees and funding.  Without money and critical skills, a technology product cannot be built.  With best-in-class engineering schools (e.g. Stanford, Berkeley) and a number of venture capital firms nearby, Silicon Valley startups have advantages over similar startups located in other parts of the world.  As Silicon Valley has produced more valuable startups, more talent and money has migrated to the area, further bolstering its advantage.
• Branding: How would you be able to convince your customers that your lemonade was higher quality, tasted better, was healthier, and that they would be getting an inferior experience drinking your neighbor’s lemonade? How would you be able to do this if your neighbor’s lemonade was made of the same exact formulation as yours?  In fact, how would you be able to do this if your product was truly inferior to your neighbor’s product?  Believe it or not, it is possible for you to win, even with an inferior product.  You could start out by creating fliers, posters, and vivid signage and posting it up throughout the neighborhood.  This would make people aware of your product and make your lemonade stand instantly recognizable.  You could attend neighborhood athletic and outdoor events and hand out samples, particularly when people are feeling most thirsty.  You could get Justin Bieber, Katy Perry, and Lady Gaga to go door to door promoting your lemonade.  You could get a famous doctor, such as Dr. Sanjay Gupta, to speak about the nutritional benefits of your lemonade.  You could even make a commercial that might display an athlete going through a rigorous workout on a hot summer day and satisfactorily drinking your lemonade to cool off.  Through such efforts, you would convince your customers that your product is superior, even if it in fact isn’t.
  • A brand is nothing more than an image or thought which appears in a customers’ mind when the name or image of that brand is mentioned or appears. Coca-Cola strategically places advertisements around events when people are most happy – e.g. sporting events, the Olympics.  As a result, people associate drinking Coke with being happy or having a good time.  Similarly, Beats headphones became extremely popular after celebrities such as LeBron James, Justin Bieber, Kobe Bryant, Lady Gaga, and a number of other athletes and entertainers were seen on TV or in videos wearing those headphones.  People associated an authority figure such as celebrity with high quality.  As a result, Beats headphones have generated excess profits despite producing an inferior quality product.
• Regulatory Advantage: Let’s say that in order for us to operate our lemonade stand we must obtain a permit to operate from the local city government.  Let’s further hypothesize that the local government is only willing to give away one permit in total.  If we were to obtain that permit, we’d effectively be the only lemonade stand allowed to operate.  This would prevent competitors from setting up their own lemonade operations and allow us to earn above average profits.
  • In the business world, many businesses enjoy competitive advantages due to a limited number of licenses granted by governments and governmental regulations which make it expensive for competitors to enter the market. For example, in order to operate a wireless network, a business must gain access to what’s known as wireless spectrum, a specific band of frequency used to transmit data wirelessly.  Wireless spectrum is scarce and auctioned off by governments.  In the USA, there is very little wireless spectrum left which is available for purchase.  As a result, the few companies which control the spectrum enjoy a competitive advantage.  In an industry such as banking, government regulations have become so onerous and expensive that a start-up is unlikely to be able to take away customers.  The government’s reporting requirements require banks to hire a large number of experts to meet such requirements.  The large regulatory expense prevents competitors from entering the industry and allows incumbents to enjoy above average profitability.
• Economies of Scale: Perhaps the most powerful form of competitive advantage is economies of scale. Before we turn back to our lemonade stand to see how economies of scale can provide a business with a competitive advantage, we must outline the difference between a fixed cost and a variable cost.
  • A fixed cost is a cost which must be incurred by the business regardless of the volume of product it sells. In the case of our lemonade stand, fixed costs would be the cost of renting the table, marketing costs (posters, signage, free samples, TV advertisements), research cost (any cost incurred to further develop the lemonade formula), and the cost of staff (any wages you would be to someone you might potentially help you run the lemonade stand).  Generally, those costs won’t change whether you sell 5 cups of lemonade or 50 cups.  A variable cost is exactly that – variable based on the volume of product sold.  In the case of our lemonade stand, variable costs include the cost of lemons, water, sugar, ice, and cups to serve the drink.  These costs are dependent on the amount of lemonade purchased by customers
  • Economies of scale develop when a business is able to sell product in extremely high volumes. A high volume of sales results in a lower fixed cost per product.  Let’s illustrate with numbers.  Let’s say you spend $100 to rent the table, create posters/fliers, hire one staff member, and develop your lemonade formula.  If you sell 20 cups of lemonade, the fixed cost per cup of lemonade is $5.  However, if you sell 100 cups of lemonade, the fixed cost decreases to $1 per cup.  This gives you a cost advantage versus potential competitors such as your neighbor.  With a cost advantage, you can lower our prices or spend more on advertising to attract more customers.  This will cause volumes to further increase, driving the cost per cup of lemonade further down.  And the cycle continues.  Economies of scale create what is called a “positive feedback loop.”
  • Most wonderful businesses benefit from some form of economies of scale. GEICO, the car insurance business famous for its quirky commercials, benefits from huge economies of scale in advertising.  GEICO spends greater than $1 billion annually on advertising, more than 3x the amount of its nearest competitor.  It is able to spend such large sums because it generates a high volume of business, much of which is the result of its advertising reach.  We all have seen a GEICO commercial and know the phrase, “15 minutes could save you 15% or more on car insurance.”  We immediately associate GEICO with low cost.  The economies of scale in the business continue to balloon, with GEICO increasing its advertising budget every year.  More advertising à more customers àmore advertising… and the positive feedback loop continues.  Another industry where economies of scale matter is the automobile manufacturing industry.  Experts say that it costs nearly $1 billion to fully design and test a new car prototype.  In order to be able to cover such a large expense, an automobile manufacturer must sell a high volume of cars.  This effectively prevents ambitious competitors from entering the industry and competing away all the profits.

Through the example of our lemonade stand, we’ve covered critical elements which could lead to a competitive advantage – (i) intellectual property/proprietary formula, (ii) low cost advantage through advantaged access to supply and/or economies of scale, and (iii) advantages developed as a result of government licenses or regulation limiting competition.  There are a few other key sources of competitive advantage which are worth discussing.

• Network Effect: Why is Facebook such a valuable business? Facebook is valuable because the value of the product is in the value of the network.  You sign up for a Facebook account because you want to stay in touch with your friends and family.  If those friends and family were not on Facebook, you would have no reason to sign up.  Let’s say you wanted to compete with Facebook.  How would you build out the same network?  How would you get people to sign up?  It would be extremely difficult because people wouldn’t want to join your platform if their friends and family weren’t on the platform.  As a result, Facebook is able to thwart competition and earn above average profits.  There are many examples of network effects businesses.  Visa is another example.  Many people carry Visa credit cards because it’s accepted everywhere.  And because many people carry Visa cards, merchants (storefronts) must accept Visa as a form of payment.  Starting a new payment network to compete against Visa is a very difficult proposition due to the strong network effect inherent in Visa’s business model.

We like to think of sustainable competitive advantage as a sort of “economic moat.” Just like a medieval castle would have a moat around it to protect it from attacking armies, a company tries to develop an economic moat around its business. The larger, deeper and more impenetrable the moat, obviously the better! The company’s fortress (rock-solid balance sheet) cannot be easily attacked by competitors. In basic economics courses one learns that if a company earns extraordinarily high profits, competition rapidly comes in, bringing the company’s profitability down to the industry’s average. In the long run, then, it is said that economic profits are eroded or arbitraged away by competition. Still, we all know there are companies that manage to be very profitable over longer periods of time. What causes these companies to be different? In a few words, the “impenetrability” of their economic moat.

Economic moats are obviously difficult to build and maintain. Companies with formidable moats can get to that position in different ways. Some are firms that have been around for a very long time, have a very strong brand that consumers will always be willing to pay a premium for. The more difficult it is for consumers to switch to alternative products, in general, the stronger the company’s moat. An impenetrable moat allows firms to charge more for their products and services (it gives them pricing power). Thus, it is easier for companies with strong moats to have and maintain better profit margins than their weaker competitors. In general, companies with solid moats can be identified by more stable profit margins over time.

Warren Buffett historically avoided investing in technology companies. That has changed a bit in recent years, and he is a strong proponent of IBM, for example. The Oracle of Omaha recommends that investors understand well how a company makes money (and the sustainability of their moat). Because technology changes rapidly, and Mr. Buffett himself admits he is not a technology expert, he preferred to stay away. Moats are always challenging to maintain, and the more rapidly the industry changes, the more difficult it is to protect the firm’s economic moat. It is easy to understand why Mr. Buffett prefers a company that does not need a particularly capable management in order to maintain its moat. Still, everything else being equal, he would be the first to admit that the better the management, the more the company will be able to sustain its moat. Thus, a capable management that fosters a purposeful company culture will go a long way towards maintaining (and perhaps even increasing) the firm’s economic moat.

A SWOT analysis is a method used to identify the strengths, weaknesses, opportunities, and threats of an organization. It involves looking both at internal and external factors. Internal factors are the strengths and weaknesses internal to the organization. External factors are the opportunities and threats that come from outside the organization. Apple’s talented employees, who have a great ability to innovate, would be an internal strength of Apple. Apple’s direct competitor Samsung, which also makes smartphones, would be an external threat to Apple. If Apple’s management routinely mistreated employees, resulting in many employees regularly quitting their jobs, that would be an example of an internal weakness. Finally, the new market in smartwatches that Apple previously hadn’t participated in was an external opportunity – one that Apple eventually capitalized on by creating Apple Watch. While analyzing a company does involve looking at the company’s numbers (i.e., its financial statements), non-numeric analysis is also needed to better understand the business and the environment. A SWOT analysis provides a great framework to do this.

A company that can generate high returns on its capital for many years will compound wealth at a very prodigious clip. * Companies that can do this are not common, however, because high returns on capital attract competitors like bees to honey. That’s how capitalism works, after all—money seeks the areas of highest expected return, which means that competition quickly arrives at the doorstep of a company with fat profits. So in general, returns on capital are what we call “mean-reverting.” In other words, companies with high returns see them dwindle as competition moves in, companies with low returns see them improve as either they move into new lines of business or their competitors leave the playing field.

But some companies are able to withstand the relentless onslaught of competition for long periods of time, and these are the wealth-compounding machines that can form the bedrock of your portfolio. For example, think about companies like Anheuser-Busch, Oracle, and Johnson & Johnson—they’re all extremely profitable and have faced intense competitive threats for many years, yet they still crank out very high returns on capital. Maybe they just got lucky, or (more likely) maybe those firms have some special characteristics that most companies lack. How can you identify companies like these—ones that not only are great today, but are likely to stay great for many years into the future? You ask a deceptively simple question about the companies in which you plan to invest: “What prevents a smart, well-financed competitor from moving in on this company’s turf?” To answer this question, look for specific structural characteristics called competitive advantages or economic moats. Just as moats around medieval castles kept the opposition at bay, economic moats protect the high returns on capital enjoyed by the world’s best companies.

Because Wall Street is typically so focused on short-term results, it’s easy to confuse fleeting good news with the characteristics of long-term competitive advantage. In my experience, the most common “mistaken moats” are great products, strong market share, great execution, and great management. These four traps can lure you into thinking that a company has a moat when the odds are good that it actually doesn’t.

Great products rarely make a moat, though they can certainly juice short-term results. For example, Chrysler virtually printed money for a few years when it rolled out the first minivan in the 1980s. Of course, in an industry where fat profit margins are tough to come by, this success did not go unnoticed at Chrysler’s competitors, all of whom rushed to roll out minivans of their own. No structural characteristic of the automobile market prevented other firms from entering Chrysler’s profit pool, so they crashed the minivan party as quickly as possible.

Contrast this experience with that of a small auto-parts supplier named Gentex, which introduced an automatically dimming rearview mirror not too long after Chrysler’s minivans arrived on the scene. The auto-parts industry is no less brutal than the market for cars, but Gentex had a slew of patents on its mirrors, which meant that other companies were simply unable to compete with it. The result was fat profit margins for Gentex for many years, and the company is still posting returns on invested capital north of 20 percent more than two decades after its first mirror hit the market.

Remember Krispy Kreme? Great doughnuts, but no economic moat—it is very easy for consumers to switch to a different doughnut brand or to pare back their doughnut consumption. (This was a lesson I had to learn the hard way.) Or how about Tommy Hilfiger, whose brands were all the rage for many years? Overzealous distribution tarnished the brand, Tommy clothing wound up on the closeout racks, and the company fell off a financial cliff. And of course, who can forget Pets.com , eToys, and all the other e-commerce web sites that are now just footnotes to the history of the Internet bubble?

Unfortunately, bigger is not necessarily better when it comes to digging an economic moat. It is very easy to assume that a company with high market share has a sustainable competitive advantage—how else would it have grabbed a big chunk of the market?—but history shows us that leadership can be fleeting in highly competitive markets. Kodak (film), IBM (PCs), Netscape (Internet browsers), General Motors (automobiles), and Corel (word processing software) are only a few of the firms that have discovered this.

So to define an economic moat, what should you look for? Here’s your list:

• A company can have intangible assets, like brands, patents, or regulatory licenses that allow it to sell products or services that can’t be matched by competitors.
• The products or services that a company sells may be hard for customers to give up, which creates customer switching costs that give the firm pricing power.
• Some lucky companies benefit from network economics, which is a very powerful type of economic moat that can lock out competitors for a long time.
• Finally, some companies have cost advantages, stemming from process, location, scale, or access to a unique asset, which allow them to offer goods or services at a lower cost than competitors.

In our experience, these four categories cover the vast majority of firms with moats, and using them as a filter will steer you in the right direction. We have thoroughly analyzed the competitive position of thousands of companies across the globe over the past several years, so these four characteristics have been boiled down from a very large data set.

One of the most common mistakes investors make concerning brands is assuming that a well-known brand endows its owner with a competitive advantage. In fact, nothing could be further from the truth. A brand creates an economic moat only if it increases the consumer’s willingness to pay or increases customer captivity. After all, brands cost money to build and sustain, and if that investment doesn’t generate a return via some pricing power or repeat business, then it’s not creating a competitive advantage. The next time you are looking at a company with a well-known consumer brand—or one that argues that its brand is valuable within a certain market niche—ask whether the company is able to charge a premium relative to similar competing products. If not, the brand may not be worth very much. Look at Sony, for example, which certainly has a well-known brand. Now ask yourself whether you would pay more for a DVD player solely because it has the Sony name on it, if you were comparing it to a DVD player with similar features from Philips Electronics or Samsung or Panasonic. Odds are good that you wouldn’t—at least most people wouldn’t—because features and price generally matter more to consumers when buying electronics than brands do.

Now compare Sony with two companies that sell very different products, jewelry merchant Tiffany & Company and building-products supplier USG Corporation. What these three firms have in common is that they all sell products that are not very different from those sold by their competitors. Take off the Sony label, and its gadgets seem the same as anyone else’s. Remove a Tiffany diamond from the blue box, and it looks no different than one sold by Blue Nile or Borsheims. And USG’s “ Sheetrock”- branded drywall is exactly the same as the drywall sold by its competitors. Yet Tiffany is able to charge consumers a lot more on average for diamonds with the same specifications as those sold by its competitors, mainly because they come in a pretty blue box. For example, as of this writing, a 1.08- carat, ideal-cut diamond with G color and VS1 clarity mounted in a platinum band sold for $13,900 from Tiffany. A diamond ring of the exact same size, color, and clarity, a similar cut, and a platinum band sold for $8,948 from Blue Nile. (That’s an expensive blue box!)

If a company can charge more for the same product than its peers just by selling it under a brand, that brand very likely constitutes a formidable economic moat. Think about Bayer aspirin—it’s the same chemical compound as other aspirins, but Bayer can charge almost twice as much as generic aspirin. That’s a powerful brand.

The bottom line is that brands can create durable competitive advantages, but the popularity of the brand matters much less than whether it actually affects consumers’ behavior. If consumers will pay more for a product— or purchase it with regularity—solely because of the brand, you have strong evidence of a moat. But there are plenty of well-known brands attached to products and companies that struggle to earn positive economic returns.

’VE ALWAYS BEEN amazed by those people who seem to have met everyone in creation. You probably know someone like this yourself—think of that friend who effortlessly schmoozes everyone he or she meets and winds up with a Rolodex the size of a bowling ball. These people create huge networks of contacts that make them desirable acquaintances, because the more people they know, the more people they can connect for mutual benefit. Their social value increases as the number of people in their network grows.

Businesses that benefit from the network effect are very similar; that is, the value of their product or service increases with the number of users. This may sound incredibly simple, but it’s actually fairly unusual. Think about your favorite restaurant. That business delivers value to you by providing good food at a reasonable price. It likely doesn’t matter much to you whether the place is crowded or empty, and in fact, you’d probably prefer it to be not terribly crowded. The value of the service is almost completely independent of how many other people use it.

Think of American express.  The rewards and perks that Amex offers users help it to compete with other credit cards, but if its cards weren’t accepted at millions of places where people want to spend money, Amex could offer triple the level of rewards and still have a tiny number of users. That huge network of merchants is what gives Amex a competitive advantage over any other company that may want to start up a new credit card. The more places you can use your Amex card, the more valuable that card becomes to you, which is a big reason behind the company’s recent push to get Amex accepted at smaller merchants like convenience stores and gas stations. Now think about how many large credit card networks there are in the United States. The top four—Visa, MasterCard, Amex, and Discover—account for 85 percent of all spending on credit cards nationwide. That’s a huge amount of market concentration, and it illustrates a fundamental reason why the network effect can be an extremely powerful competitive advantage: Network based businesses tend to create natural monopolies and oligopolies. As economist and academic Brian Arthur has succinctly put it, “Of networks, there will be few.”

We’ve already talked about Amex’s moat, and the way the network effect helps Microsoft is fairly easy to understand as well. Lots of people use Word, Office, and Windows because, well—lots of people use Word, Office, and Windows. It’s hard to argue that Windows is the acme of PC operating systems, but its massive user base means that you pretty much have to know how to operate a Windows based PC to survive in corporate America. Word and Excel are similar. Even if a competitor showed up on the scene next week with a word processor or spreadsheet that was five times easier to use and half the price, it would have a hard time gaining traction in the market because Excel and Word have become (like it or not) the common language of knowledge workers around the world.

Saying that eBay dominates the U.S. online auction market is like saying that Ansel Adams took some decent snapshots of America’s national parks. “Dominates” is putting it mildly. As of this writing, eBay had at least an 85 percent share of Internet auction traffic in the United States, and because it is virtually certain that visitors to eBay spend more per transaction and are more likely to buy than are visitors to rival sites, eBay’s share of dollars spent in online auctions is likely much higher than 85 percent. The reason why should be obvious after the foregoing discussion of the network effect: The buyers are on eBay because the sellers are there, and vice versa.

As you can see, the network effect is a pretty powerful competitive advantage. It is not insurmountable, but it’s a tough one for a competitor to crack in most circumstances. This is one moat that is not easy to find, but it’s worth a lot of investigation when you do find it.

WHEN WAS THE LAST TIME you changed banks? Unless you have moved recently, I’ll bet the answer is “It’s been awhile,” and you wouldn’t be alone in sticking with your current bank. If you talk to bankers, you’ll find that the average turnover rate for deposits is around 15 percent, implying that the average customer keeps his or her account at a bank for six to seven years.

When you think about it, that’s a curiously long time. After all, money is the ultimate commodity, and bank accounts don’t vary a whole lot in terms of their features. Why don’t people switch banks frequently in search of higher interest rates and lower fees? People will drive a couple of miles out of their way to save a nickel per gallon on gasoline, after all, and that’s only a buck or two of savings per fill-up. A bank account that doesn’t nickel-and-dime you for late fees and such could easily save you a lot more than that cheap out-of-the-way gas station can. The answer is pretty simple, of course. Switching from the nearby gas station to the cheaper one costs you maybe 5 to 10 minutes extra of time. That’s it. Moreover, you know with certainty that is the only cost, because gasoline is gasoline. But switching bank accounts involves filling out some forms at the new bank and probably changing any direct-deposit or bill-paying arrangements you may have made. So, the known cost is definitely more than a few minutes. And then there’s the unknown hassle cost that could occur if you’re current bank delays or mishandles the transfer to your new bank—your paycheck could go into limbo, or your electricity bill might not get paid.

Small companies keep using QuickBooks because it becomes part and parcel of their daily operations, and untangling it from their business to start afresh with a new accounting program would be costly, and possibly risky as well. This is perhaps the most common type of switching cost, and we see it in a wide variety of companies. Look at Oracle, the giant software company that sells massive database programs that large companies use to store and retrieve huge amounts of data. Because data are rarely of any use in their raw form, Oracle’s databases typically need to be connected to other software programs that analyze, present, or manipulate the raw data. (Think about the last item you bought online—the raw data about the product was probably sitting in an Oracle database, but other programs pulled it together to show you the web page from which you made your purchase.)

So, if a company wanted to change from an Oracle database to one sold by a competitor, not only would it need to move all the data seamlessly from the old database to the new one, but it would also have to reattach all the different programs that pull data from Oracle. That’s a time-consuming and expensive proposition, not to mention a risky one—the conversion might not work, which might result in a big business disruption. A competing database would have to be phenomenally better (or cheaper) than an Oracle database for a company to choose to pay the massive cost of ripping out its Oracle database and installing another one.

Switching costs can be tough to identify because you often need to have a thorough understanding of a customer’s experience—which can be hard if you’re not the customer. But this type of economic moat can be very powerful and long-lasting, so it’s worth taking the time to seek it out.

Large distribution networks can be the source of tremendous competitive advantages, and you can easily see why when you think about the economics of moving stuff from point A to point B. Let’s look at the fixed and variable costs of running a fleet of delivery trucks. The trucks themselves—whether purchased or leased—are a fixed cost, as are the salaries of their drivers and most of the gasoline that the trucks need to consume as they trundle along their routes. The only real variable costs are overtime wages for busy periods, and some proportion of the gas. (You might think of the fixed fuel cost being what is needed for the truck to complete its normal route, and the variable cost being what’s consumed if the truck needs to go to an out of-the-way location not on the usual route.)

Although building and operating the delivery network is an expensive proposition for a base level of service, the incremental profit on each item that the truck fleet delivers is enormous. Think about it—once the fixed costs are covered, delivering an extra item that is on a delivery route is extremely profitable because the variable cost of making an extra stop is almost nothing. Now imagine that you need to try to compete with a company that has an established distribution network. It has likely covered its fixed costs and is making large incremental profits as it delivers more stuff, while you’ll need to take on large losses for a time until (if ) you gain enough scale to become profitable. One of the main reasons, in fact, that United Parcel Service (UPS) has much higher returns on capital than rival FedEx is that it earns a larger proportion of its operating profits from door-to-door delivery of packages, as opposed to overnight letter services. A dense ground delivery network has much better returns on capital than an overnight express service. A delivery van that’s only half full will still likely cover its costs, whereas a half-full cargo jet with time-sensitive packages likely will not.

Cost advantages can sometimes be durable, but they can also disappear very quickly, so as an investor you need to be able to determine whether a company’s cost advantage is replicable by a competitor. Lots of companies over the past few years have puffed their chests out about how they lowered costs by moving a call center or manufacturing facility to some low-cost region of the world—China, India, the Philippines, you name it. They act as if management’s collective IQ doubled the day some middle manager suggested that the company source low-end parts from a factory with 80 percent lower labor costs. This is not genius, nor is it a sustainable competitive advantage, because those same low-cost resources are very likely available to any company that wants them. If one auto-parts supplier starts sourcing low-value-added components from China, how long will it take its competitors to make the same phone calls and set up similar supply lines? Not very long at all, because the longer those competitors wait, the more business they are likely to lose as the high-cost producers in a commodity industry. In a globalized economy, using the lowest-cost inputs available is the only way to stay in business for companies operating in price-sensitive industries. Needless to say, cost advantages matter most in industries where price is a large portion of the customer’s purchase criteria.

Cost advantages can stem from four sources: cheaper processes, better locations, unique assets, and greater scale. Scale-based cost advantages themselves can come in many forms, and they are so important to understand that I devote all of Chapter 7to helping you understand when bigger really is better. We walk through the other three types of cost advantages in this chapter.

First, let’s return to waste haulers and aggregate producers.  In addition to having regulatory moats, because few communities want a new landfill or gravel quarry in their neighborhood, these types of businesses have a solid location-based cost advantage as well. The further that a garbage truck has to travel to a landfill, or that a dump truck full of gravel has to travel to a construction site, the more it costs to dump the garbage or deliver the gravel. So, companies with landfills and quarries located closer to their customers almost invariably have lower costs, which means competitors have a hard time cracking their markets. We can look at the quarry-level economics of an aggregate company and see this clearly. Stone, sand, and gravel cost roughly $7 per ton at the quarry site, and an additional $0.10 to $0.15 per ton for every mile spent on the back of a truck getting to the delivery site. So, just five to seven miles of transport increase costs by 10 percent, which is passed on to the customer. In practice, these costs mean that aggregate companies have basically a mini-monopoly on construction customers located fairly close to the quarry, and relatively little competition within the 50-mile radius that is roughly a quarry’s addressable market. Cement plants have similar economics, and similar pricing power within a given cement plant’s radius. Ever wonder why you frequently see an old cement plant near a city center or in some other incongruous place? It’s because that plant is likely the lowest-cost supplier of cement by far to construction projects in that area, and is probably incredibly profitable—which means it pays a lot of taxes, which helps its owner to fend off local politicians who might want to put up condos on the site. Like quarries, cement plants often create mini-monopolies in their immediate vicinity.

A third type of cost advantage that is generally limited to commodity producers is access to a unique, world-class asset. If a company is lucky enough to own a resource deposit with lower extraction costs than any other comparable resource producer, it can often have a competitive advantage.

Cost advantages can be extremely powerful sources of competitive advantage, but some are more likely to last a long time than others. Process-based advantages usually bear close watching, because even if they do last for some period of time, it’s often because of some temporary limitation on competitors’ ability to copy that process. Once that limitation disappears, the moat can get a lot narrower very quickly. Location-based cost advantages and low costs based on ownership of some unique asset are much more durable and easier to hang one’s analytical hat on. Companies with location advantages often create mini monopolies, and world-class natural resource deposits are by definition pretty hard to replicate. The big kahuna of cost advantages, of course, is scale, and scale advantages can create extremely durable economic moats. When is bigger really better? That’s the subject of the next chapter.