The importance of a moat in tech stocks

A moat

Technology companies and startups can be very good plays in uncertain times. I am a firm believer of the Silicon Valley mantra “Software will eat the world” famously said by Ben Horowitz in 2011. Furthermore, AI and other revolutionary tech will have its share at the pie. But there are clear differences in these companies and what another famous investor Buffet likes to say is that he doesn’t buy companies without a moat. But what is a moat in this context?

What’s a moat in tech?

The term economic moat, popularized by Warren Buffett, refers to a business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms. Just like a medieval castle, the moat serves to protect those inside the fortress and their riches from outsiders.

Investopedia

Translated to the software world it means that the product has the users locked in due to either network effects, a unique selling point or both. An example of that is Facebook. At the start its moat was weak but now it has all the users locked in because of the network effects that it’s pointless to build something else as a competitor. Another example is my favorite tech stock: GOOG which is a cliche but it fits all the criteria. They didn’t have a network effect because they provided a service to the end customer. But their unique selling points were so strong and their tech was so ahead of the other competitors that they took over the market. So what I am really saying is that it’s prudent to avoid tech stocks without a moat.

Cloudflare (NET) as an example

Given I have a fairly good technical background in software this is a company that I admit I bought but I will sell after actually trying to use their product. What Cloudflare (NET) is selling is an edge Content Delivery Network (CDN) that quite a few companies use. But their flagship product as a CDN is widely available in other providers and for free. Their client lock in is essentially non-existent because at whatever point in time someone can just copy paste the content into another provider and her business will run uninterrupted. There is no vendor lock in, no moat.

Getting more technical, check out the site that most developers use to build web applications: React Documentation. If you go to the deployment section you can see a gazillion of competitors that offer more or less the same services. Yes Cloudflare has a stable and good business with DDOS attacks and may have a little bit better speed but their product can be very easily disrupted by the next startup that goes out of Y Combinator or any other cloud provider including Amazon, Google, Microsoft, Netlify etc. In other words, this stock can go out of business and has a higher risk of ruin.

P.S If you find value in this article please consider subscribing to the newsletter.

Disclaimer: The information on this site is for informational purposes and isn’t financial advice. We cannot guarantee that you will have the same results as we have nor can we guarantee that the information shared here is appropriate for you. This is not financial advice and not given by professionals.

Tags:

Leave a Reply

Your email address will not be published.