What is an Economic Moat?

Conceptualized and named by Warren Buffett, an economic moat is a distinct advantage a company has over its competitors which allows it to protect its market share and profitability. It is often an advantage that is difficult to mimic or duplicate (brand identity, patents) and thus creates an effective barrier against competition from other firms.

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Moat: My Favorite Financial Term

Understanding an Economic Moat

Every successful company understands that the main threat to their continued success will be from competitors, and keeping them at bay is critical to sustaining their dominance. With the passage of time, they are likely to see an erosion to their bottom line as competitors eat away at their market share. Which is why a business that intends to remain dominant has to establish an economic moat. Economic moat describes a company's competitive advantage derived as a result of various business tactics that allow it to earn above-average profits for a sustainable period of time.

This is important not only to the company's bottom line but also to potential investors seeking to maximize their portfolios by including companies that will maintain their performance edge. By establishing a defensible competitive advantage a company can fashion a wide enough economic moat that effectively curbs competition within their industry. Essentially, the wider the economic moat, the larger and more sustainable the competitive advantage of a firm.

An intangible asset, such as a company crafting a well-known brand name (Nike), pricing power edge (Apple), cost advantages (Walmart), making it costly for customers to switch products (cell phone companies), efficient scale, and network effects are all advantages that businesses can utilize to create a wide economic moat.

The most obvious financial characteristics that companies with a wide economic moat have is that they usually generate large amounts of free cash flow and have a track record of strong returns.

Key Takeaways

  • An economic moat is a distinct advantage a company has over its competitors which allows it to protect its market share and profitability.
  • It is often an advantage that is difficult to mimic or duplicate (brand identity, patents) and thus creates an effective barrier against competition from other firms.
  • The most obvious financial characteristics that companies with a wide economic moat have is that they usually generate large amounts of free cash flow and have a track record of strong returns.

Sources of Economic Moats

A company that is able to maintain low operating expenses in relation to its sales compared to its peers has cost advantages, and it can undercut its competition by lowering prices and keeping rivals at bay. Consider Wal-Mart Stores Inc., which has an immense volume of sales and negotiates low prices with its suppliers, resulting in low-cost products in its stores that are hard to replicate by its competitors.

Intangible assets refer to the patents, brands and licenses that allow a company to protect its production process and charge premium prices. While brands are typically derived from superior product offerings and marketing, patents are obtained as a result of companies' filings with governments to protect know-hows for a specific period of time, typically 20 years. Pharmaceutical companies earn high profits due to patented drugs after spending billions on research and development.

Efficient scale arises when a particular market is best served by a limited number of companies, giving them near monopoly聽statuses. Utility firms are examples of companies with efficient scale that is necessary to serve electricity and water to their customers in a single geographic area. Building a second utility company in the same area would be too costly and inefficient.

Switching costs is another type of economic moat, which make it very time-consuming and expensive for consumers to switch products or brands. Autodesk Inc. offers various software solutions for engineers and designers that are very difficult to learn. Once an Autodesk customer starts using its software, he is unlikely to switch, allowing Autodesk to charge premium prices for its products.

The network effect can further fortify a company's economic moat by making its products more valuable the more people use them. An example of a network effect is online marketplaces such as Amazon and eBay, which are widely popular among consumers because of the large quantity of people buying and selling various products through their platforms.