Economic Moats: Efficient Scale

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Economic Moats: Efficient Scale

As an economic moat, efficient scale is a competitive advantage that some companies enjoy.

What is efficient scale?

Efficient scale is a dynamic in which a limited market is being efficiently served by one or a very small number of competitors. When a company serves a market that is limited in size, new competitors may not have an incentive to enter. New entrants would cause returns for all players to fall well below the cost of capital. Therefore, it doesn’t make economic sense to have more than one or a few. The ones that are already in it will benefit. Generally, when you have a market that is limited in size—and that’s a key attribute of this competitive advantage—that alone is going to keep competitors at bay.

What industries have efficient scales?

You may see efficient scales in areas where there are natural geographic monopolies. One such area is the airport business. While airports are not publicly traded in the United States, they are elsewhere around the world. Most cities can support only one airport; some of the bigger cities have two or three. For the vast majority of cities, there is a 50- or 60-mile natural geographic monopoly on that area.

Another example of a geographic monopoly is racetracks. Though it would be possible to build a second racetrack in a city that already has one, there typically is not enough demand to support two racetracks.

Utilities, certain telecom companies, and certain energy companies fall into this category, too. Of course, the utilities also have the overlay of regulation, but even if they did not have the regulation—there are areas of the world where utilities are unregulated—we still see these natural geographic monopolies.

Thus, some markets are just natural monopolies or natural oligopolies.

How narrow is their moat?

There are different levels of companies’ moat ratings. There is narrow and there is wide, and the wide moats are the ones that have the strongest, most sustainable competitive advantages. Where do companies with efficient scales fit in?

Answer: They are found in both. An example of one with a wide moat is a tech company like Lockheed Martin: We need only one next-generation strike fighter supplier. Companies like that are efficient scale stories, and they are in the wide-moat bucket. But there are many more in the narrow-moat bucket, and that’s because essentially the entirety of our utilities coverage universe and a large number of telecom companies are going to fall into this efficient scale bucket. So, it’s relatively rare in the wide-moat universe, but in the narrow-moat universe, this should be slightly more common.

Given that there is a certain market of a certain size that is served by these companies, would we see them as more mature or slower-growth, maybe more likely to pay a dividend because of that? Even though they do have that competitive advantage, maybe their prospects for gangbusters growth aren’t as high as those of another kind of company? A key attribute of efficient scale is a limited market, and that implies that these companies are not necessarily growing, because a rapidly growing market provides lots of opportunities for competitors to come in. But if a company is benefiting from this particular competitive advantage, it is going to be in a relatively low-growth industry.

Thus, they are going to be typically more mature, higher-dividend-paying companies.