What does an economic moat mean?

Summary

• A business having a strong moat possesses a competitive advantage that is both strong and sustainable for the long run.
• The term has been inspired by the moat that used to surround medieval castles to protect them.
• Warren Buffett has also highlighted the importance of buying businesses with deep moats, as they are protected from competitors.

The term “economic moat” has been popularised by Warren Buffett which refers to a long-term competitive advantage that protects a company’s foothold in the marketplace. The term is inspired by the moat that used to surround medieval castles in the earlier times to protect its valuables from invaders. A business having a strong moat possesses a competitive advantage that is both sustainable and strong.

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Investment maestros, such as Warren Buffet, liken buying companies to buying castles. Warren Buffett emphasises the importance of buying businesses having sustainable and deep moats. These moats protect the business from competitors and can, therefore, maintain strong profits.

Read More: What is an economic indicator?

Why is an Economic Moat Important to Investors?

While investing, investors generally consider two things; the magnitude of return in excess of the cost of capital and for how long the company can be expected to continue to generate expected returns. To garner large profits, a company must first have to outsmart competition with a competitive advantage. These advantages can come from a number of things such as patents, lower production costs, high switching costs, etc. Any of these factors can be especially helpful in retaining its customer base alongside differentiating it from its competitors.

To have a sustainable stream of profits and be considered a moat, the competitive advantage must be durable. Thus, it can provide value for investors in the long run.

Read More: What is imperfect competition?

How to determine whether a company has an economic moat or not?

Investors generally don’t often talk about the depth of a moat, yet it's a good way of thinking about how much money a company can make with its advantage. To determine whether a company possess an economic moat or not, here are four steps that could be followed:

1. Evaluate the firm's historical profitability

The first parameter to be evaluated is whether the firm had been able to generate a solid return on its assets and on shareholder equity? This is perhaps the most important component in identifying the economic moat of the company. While much about assessing a moat is qualitative in nature, the core analysis still relies on solid financial metrics.

2. Try to identify the source of those profits

Is the source of revenue an advantage exclusive to the company, or is it one that other competitors can easily imitate? The harder it is for competitors to imitate a moat, the more likely the company has a barrier in its industry and a source of economic profit.

3. Estimate how long the company will be able to keep up with the competition

Investors refer to this time period as the company's competitive advantage period. This period can be as short as several months or as long as several decades. The longer the competitive advantage period that a company maintains, the wider its economic moat would be.

4. Think about the industry's competitive structure

Does the respective industry has many profitable companies or is it hypercompetitive with only a few companies scrounging for the last dollar? Industries with high competitiveness will likely offer less attractive profit growth over in the long run.

Read More: Economic Moats versus Stock Valuation

Examples of economic moats

Anything that gives a company long-term competitive advantage can be its moat, therefore virtually, there could be a huge number of moats. Some of the examples are:

1. Switching costs: 

Switching costs are the expenses that is borne by a customer if he wants to switch to another similar product or service. As the switching costs becomes higher, the customer becomes more locked in with a company’s products or services. Switching costs can also be in the form of loyalty points.

2. Network effect: 

The network effect takes place when the value of a business and existing customers increases as more people use a service or product. It creates a moat since the business increases its value and competitiveness over time. 

3. Brand value:

Brand value is another moat which is essentially an idea that a company is able to generate more revenue or charge a premium price based on its brand recognition. This is based on the fact that customers generally believe there is a correlation between well-known brands and quality products.

4. Protection:

A company’s products can be protected through copyrights, patents, trademarks, or operating rights. Patents help a company create a moat by protecting its product that they spent R&D funds on, so that they cannot be replicated.

5. Size Advantage:

Being gigantic in size, can sometimes become an economic moat for a company. At a certain size, a firm is able to achieves economies of scale, helping it to lower its per unit cost. This reduces overhead costs in areas such as advertising, financing, production, etc.