Investor Warren Buffett first coined the term economic moat. It is used to describe a company’s competitive advantage. The moat’s width and depth surrounding the business’s castle determine how protected it is from the competition.
An economic moat is a company’s unique strength over its competitors—the more unbreachable the moat, the more protected its market share and profitability. A moat can be in the form of scale of production, brand strength, being a low-cost provider, or rate of innovation.
What is the definition of an economic moat?
Every successful company faces competition. Growing companies send out strong signals to others that their business practices are profitable and, if copied, may also be profitable for the competition. This impending threat is ever-present, and companies must protect themselves from imitators. Successful companies must create high barriers to entry if they are to protect their earnings. If not, the competition will eat away at their market share and make it increasingly challenging to be profitable.
An economic moat is a way of visualizing this barrier; the company is the castle, ruled by an able king, surrounded by a moat that protects it from intruders. The deeper and wider the moat, the stronger its competitive advantage and the more likely it will last. Over time the manager (king) must do everything they can to further deepen and widen the moat so that their earnings become increasingly protected. The moat can come in many forms that are usually unique to that industry. Investors must understand the durability of a company’s moat in the context of its sector before deciding to invest.
Forms of economic moats
Intangible assets
The most common economic moat is from a company’s intangible assets. These include its brand, patents, licenses, trademarks, and company culture. A strong brand allows businesses to charge a premium for its products and services over its competitor’s products and services, even when the difference between them is negligible. Although it is difficult to quantify the amount intangible assets contribute to a company’s earnings, they are the primary source, often the strongest, of competitive advantage.
For some sectors, brand recognition is vital for thriving. Consumer goods rest their company’s reputation on their brand. For example, Coca-Cola is the carbonated soft drink company in the world. Its brand is associated with joyful occasions and has been imprinted on people since childhood. People chose Coca-Cola products over the store brand, in part to this imprinting. This allows the company to charge a higher price than the store brand, generating more revenue per unit. This power is crucial for commodity-based businesses.
Using Coca-Cola as another example, processes unique to the company, such as its secret syrup formula, are unique to that brand and difficult to copy. This uniqueness and complexity allow Coca-Cola to offer its customers a product that no other competitor can exactly imitate. Its copyright and trademark are also barriers to entry; the Coca-Cola brand is one of the most recognizable brands in the world, and no one can use it without permission. Furthermore, it owns over 6,000 patents, increasing the difficulty for rivals to make, use, or sell inventions that may contribute to their revenues.
Low-cost advantage
Companies can deliver their goods or services at a lower cost than their competitors. This allows them to undercut their rivals on price and divert revenue that would have gone to their competitors to themselves. Low-cost providers also often control market prices, giving them a further advantage over their competitors. According to Morningstar, the low-cost advantage moat is the second most frequent economic moat, after intangible assets advantage. A low-cost advantage is most commonly achieved through economies of scale, access to cheaper raw materials, lower distribution costs, and lower manufacturing costs. Due to the increasing level of globalization, being a low-cost provider is becoming ever more complex. We have seen US manufacturing decline due to low-cost providers from China.
For example, probably the world’s most famous low-cost provider, Walmart is synonymous with low-cost items. It has excellent vendor relationships, an efficient supply chain, and economies of scale that most rivals cannot compete with. This allows it to undercut its competitors and attract more customers to its stores. Its 5,000 stores will give it incredible bargaining power with suppliers. Its 265 million weekly customer base attracts many vendors willing to cut their prices to get their products into the stores.
Efficient scale
Efficient scale is when a business serves a large percentage or majority share of a market. Their share and efficiency deter new entrants due to a high barrier from the capital needed to buy the volumes and infrastructure needed to be price competitive. The lower volumes that a new entrant will purchase resources will cause lower margins. In addition, if there are a small number of dominant players in a specific industry, if a new competitor were to enter, it would cause the profits for all participants to fall due to increased price competitiveness. Thus, making it illogical for the new entrant to join. This moat is particularly common in capital-intensive industries.
For example, for a new electricity company to compete with an existing one, they would have to build their power stations, transformers, transmission lines, and distribution lines. This not only would be incredibly expensive, but the returns would be meager due to the already tight margins. Though the efficient scale is one of the strongest moats, it is also one of the least common.
Network effect
The network effect, made famous by social media, is becoming increasingly more common. The increase of a product or service value with every user joins its network, thus attracting more users to the network. It can lead to rapid exponential growth of a company, which is enabled by its digital platform. Unlike capital-intensive industries, technology companies can produce incredible returns on small amounts of CAPEX. The network effect can be one of the deepest and most resilient moats, especially in the world of technology. It can exist in the form of a marketplace, such as eBay, data, such as Google, or a platform, such as Facebook.
For example, Amazon is the largest online marketplace by revenue in the world. The more companies on the platform listing their products, the more customers are attracted. A large customer base means more sales, which means customers can reduce prices. These low prices and broad offerings attract more customers, and the cycle continues. Once established, it is tough for new entrants to compete.
Switching costs
Often combined with other economic moats, high switching costs can be another way for a market leader to disincentive customers from leaving. The switching price is higher than the value they would receive from a competitor. Switching costs can also be based on psychology, time, or effort. The market leader may also have other moats, such as the network effect, making switching more challenging. The company also often has pricing power when switching to a competitor is too cumbersome or expensive. This can lead to further profit and growth.
For example, consider a large company that runs entirely on Windows. If they were to switch to Apple, they would have to replace all computers, purchase all new software (if it exists for Apple), and have significant downtime to transfer over to the new ecosystem. The cost of migrating to another operating system would likely cost more than the value the company would receive.
How durable is a company’s moat?
When deciding to invest in a company, investors must ask themselves how long the moat will last? If the moat is not durable, it is only a matter of time before a competitor takes it away. Moats should be deep, wide, and full of deterrents. A company can have one extremely strong moat, or it can have a combination of moats. Either way, a strong moat should be able to fend off competitors for many years and protect its profitability. Buying at a discount significantly increases the returns when an investor has found a company with a long-term competitive advantage. However, the strongest companies often trade at a premium, so great patience must be exercised to purchase at a bargain.
