What is Economic Moat?

If you look up the word ‘moat’, the definition is this – “a long wide channel dug around a castle and filled with water to make it difficult for enemies to attack.” However, in the context of the stock market, an economic moat is a competitive edge that one company has over other companies, that allows it to perform better in the long run.

The term ‘economic moat’ has been conceptualized by none other than the Oracle of Omaha – Warren Buffett. He opines that buying businesses is like buying castles. Buffett gives due importance to buying businesses with deep moats. Since these companies are protected from competition, they consequently maintain strong and sustainable gains.

Understanding Economic Moat

Every established company recognizes that one of the biggest threats to its continued success is potential competitors. Keeping these competitors at bay and staying ahead is essential in maintaining market superiority. As competitors chip away a share in the market, a company is most likely to witness a blow to its net income. This is why a company needs to establish an economic moat.

This is not only essential for a company's financial health but also, for potential investors. Two chief factors that concern investors are the extent of profit made and the period for which a company can be expected to generate sizable returns. To begin and sustain large profits, a company must first and foremost achieve a competitive advantage. This advantage may arise as a consequence of several things – patents, lower production costs, streamlined logistics, high switching costs, etc. Any such factor can aid in differentiating a company from its competitors and therefore in retaining customers.

Fundamentally, the greater and more sustainable a firm's competitive edge, the broader is their economic moat. By creating a legitimate edge, a company can create a broad enough economic moat to successfully restrict competition within the market. Companies with a broad economic moat typically have large amounts of free cash flow and a track record of strong gains.

Sources of Economic Moat

There are multiple ways through which companies can create an economic moat. They include:

• Brand value

  Brand value means that a company can generate more revenue by charging premium prices because of brand recognition in the market. The general perception is that there is a direct correlation between well-known brands and quality products.

  A company’s brand is based on the convenience offered, good customer service, and innovation. For instance, developing their brand value over the last decade, the clothier “Zara” is widely favored over other brands and can charge a premium for their products. This is a strong moat in action.

• Network effect

  The network effect occurs when the value of a company and its existing customer's increases as more people use or buy a service or product. As a result of its role as a facilitator, the company creates value for itself and others. It indicates that consumers are compatible with one another and receive increasing value from it. The more customers there are, the easier it is to sell things. In terms of an economic moat, such a scenario is ideal.

  Facebook is a classic example of the culmination of the network effect. As the Facebook network grows larger, there is added incentive for more people to join and use Facebook.

• Switching costs

  When it would be too expensive or onerous to stop using a company's products, the company usually possesses pricing power. The more difficult it is for a consumer to switch to a competitor's service, the wider the moat that forms around the incumbent. A switching cost is typically characterized by a mix of the price, inconvenience, risk, and time necessary to shift platforms. This type of buyer lock-in acts as a moat since it improves a customer's lifetime worth, resulting in a unit economics advantage that prevents competitors from snatching them. When the topic of switching prices emerges, it is frequently in the context of customer dissatisfaction.

• Horizontal differentiation

  When customers prefer a certain product to its competitors, then there is a horizontal differentiation. An example is cigarette brands. Most cigarette smokers will purchase the same brand out of habit. A company that can command loyalty from its customers can maintain profits long term and in this manner, has a moat.

• Production complexity and protection

  Unique processes that are tough for competitors to imitate, make good economic moats, as they tend to be substantially resistant. Patents, copyrights, trademarks, branding, regulatory licenses, and other such intangible assets allow a business to shield its production methods and charge higher costs. For example, Marvel and DC both copyright their characters.

Types of the economic moat

There are several ways by which an economic moat can be created. Let us explain a few below.

• Cost advantage moat

  This is a crucial type of economic moat. Competitors are not permitted to make the mirror image of another's product or brand. This way, the company gains a cost advantage.

• Intangible assets moat

  Intangible assets such as patents, trademarks, and brand recognition can also be used to create an economic moat, allowing businesses to charge higher prices for their as compared to other direct competitors.

• High switching costs moat

  When competitors switch their preferences from one company to its customer, a huge disruption cost occurs, and this is very high for customers of a company with an economic moat.

• Size advantage moat

  A sizable company will be able to achieve economies of scale, allowing it to produce more units with lower input costs. Thus, the economic moat is directly impacted by the company's size.

• Soft moats

  There are instances in the company where a moat exists, but it is hard to ascertain and explain. These are known as soft moats.

Final word

An economic moat exists if a company has a strong and sustained competitive edge. It helps a company in maintaining desired profitability even in volatile situations. A company with a strong economic moat is more valuable to investors. To develop a strong portfolio, it is advisable to look for companies with economic moats and more importantly, to invest in companies or sectors that you are capable of analyzing.