Economics of IT Providers

Courtesy:  37signals

In business, I look for economic castles protected by
unbreachable ‘moats’.”
-Warren Buffett

According to Buffett, the wider a business’ moat, the more likely it is to stand the test of time.

In days of old, a castle was protected by the moat that circled it. The wider the moat, the more easily a castle could be defended, as a wide moat made it very difficult for enemies to approach. A narrow moat did not offer much protection and allowed enemies easy access to the castle. To Buffett, the castle is the business and the moat is the competitive advantage the company has. He wants his managers to continually increase the size of the moats around their castles.

When looking to purchase a business, Buffett pays careful attention to a business he understands not just in terms of what the business does but also of “what the economics of the industry will be 10 years down the road, and who will be making the money at that point.” He is “also looking for enduring competitive advantages.” This, in a nutshell, is what makes a company great: the width of the moat around the company’s core business.

To be more concrete, MorningStar provides you with these cues:

Low-Cost Producer: Firms that can figure out ways to provide a good or service at a relatively low cost have an advantage because they can undercut their rivals on price. Dell Computer is a textbook example of a low-cost producer because its large size allows it to negotiate favorable component costs, and its direct-sales distribution system allows it to sell PCs more efficiently than rivals who use resellers.

High Switching Costs: Porter defines switching costs as a barrier to entry that involves the one-time inconvenience or expense a buyer incurs to change over from one product or service to another. Buyers in these cases often need a big improvement in either price or performance to make the switch to another product worthwhile. Medical-device companies Biomet and Stryker benefit from high switching costs because, for example, a surgeon would have have to forgo the comfort and familiarity of doing procedures with one artificial joint product. And because the surgeon would have to be trained to use competing products, he or she would also have to contend with lost time and money resulting from not performing as many surgical procedures.

The Network Effect: The network effect occurs when the value of a particular good or service increases for both new and existing users as more people use that good or service. It can also occur when other firms design products that compliment an existing product, thereby enhancing that product’s value. For example, the fact that there are literally millions of people using eBay is the thing that both makes eBay’s service incredibly valuable and makes it all but impossible for another company to duplicate its service.

Intangible Assets: Intangible assets generally refer to the intellectual property that firms use to prevent other companies from duplicating a good or service. Of course, patents are the most common economic moat in this category. In techland, Qualcomm’s patents give it a strong moat in the cellphone industry…A strong brand name can also be an economic moat—just consider consumer-product companies like Coca-Cola and Gillette.

 

Did I hear it right, patents? Yeah, right!

Business is business. Although deep in your heart you may object to  patents (yes, I hear you all open source developers), this is reality so deal with it.

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