What is an Economic Moat?
An economic moat refers to the distinct advantages a business has over its competitors, which allows it to protect its market share and long-term profitability from competing firms.
The term was inspired by the moats surrounding medieval castles, which protected the valuables inside from outsiders. It was made popular by Warren Buffet, who stated that buying businesses is like buying castles and emphasized the importance of finding companies with solid moats.
Importance of Moats
An established company's continued success will depend on how it protects itself from competitors, who, given time, will eat away at their market share and erode their bottom line.
Once a firm establishes competitive advantages, it can generate increased profits, which is an incentive for competing firms to copy the methods of the leading firm, and use them as inspiration for better methods.
Through secure competitive advantages and durable businesses, a company can fashion a wide economic moat that curbs nearly all competition within their industry.
Types of Moats
Moats are generally hard to mimic or duplicate and thus create an effective barrier against competition. There are several ways in which a company creates an economic moat:
The network effect is a phenomenon whereby increased numbers of participants improve the value of a good or service. Network effects are especially important for most software and technology companies or platforms.
An example of network effects is in online marketplaces such as Amazon, which is popular among consumers because of the enormous number of people buying and selling various products through the platform.
Network effects also have a strong presence in online gaming. There are usually 3 to 4 million people playing Fortnite concurrently at any point in time. Players would be less inclined to play the game if fewer people were playing.
Low Cost Producer
A cost advantage that competitors cannot replicate can be an effective economic moat. Large enterprises can achieve superior economies of scale—the cost advantages experienced with increased production, as costs are spread out over more goods.
These companies tend to dominate the core market share of their industry, while smaller players occupy the niche markets. They can undercut and squeeze out competition that attempts to move in.
Consider Costco, whose model benefits from a large and growing member base. Their immense volume of sales enables them to negotiate low prices with suppliers. It allows them to give customers the lowest prices possible on a per unit basis that are hard to replicate by its competitors.
A capital-intensive moat is where it would cost so much for a competitor to come into play that it discourages most of the competition.
One of the main reasons a duopoly exists with airliner manufacturers Airbus and Boeing is because of how capital intensive it is for new competitors. Consider the amount of capital required for any competitor to build a prototype, get it approved by regulators, set up a supply chain, get a sufficient number of orders, and so on.
Switching costs are the costs a consumer pays to switch from one product or service to a competitor’s, which may cause them to incur significant business risk.
For example, switching CRMs from Microsoft Dynamics to Salesforce while running the business is like trying to swap out the airplane engine while it is flying. It takes a lot of time to migrate all the existing data and train people on the new system.
Competitors have a difficult time taking market share away from an established player because of these cumbersome switching costs.
Strong brand name recognition allows a company to charge a premium for their products, boosting profits. Consumers love Apple products for their design and how powerful yet user-friendly they are.
Most importantly, Apple's product ecosystem keeps consumers coming back again and again for new models despite all the alternatives on the market.
Intellectual Property and Secrets
Some businesses are built on secrets, patents, licenses, and intellectual property, which allow them to protect their processes and charge premium prices. These intangible assets can give businesses supreme advantages over competitors.
Think of why Disney or other large tech companies are buying gaming franchises. Video games have valuable intellectual property that they can use in other ways while benefitting from their scale and distribution advantages.
Another example are pharmaceutical companies, who can earn high profits while owning exclusive rights to a life-changing drug on their patent for 20 years.
Regulatory moats are when laws and regulations make it very difficult for anyone to enter an industry. Railways are highly regulated, which deters competition as approvals from federal governments, state/provincial-level governments, and other regulatory bodies are needed.
A prime example was how Canadian National Railway (CNR) had to drop its bid for Kansas City Southern (KSU).
Monopolistic businesses can act as a strong economic moat as consumers have little to no option of from whom they get their product or service.
Usually, a single utility firm serves electricity and water to customers in a given geographic area. Building a second utility company that serves the same area would be inefficient.
Economic moats are generally difficult to identify while being built and are much more easily observed in hindsight.
Not only are moats important to a company's bottom line, but they are also valuable potential investors seeking to maximize their portfolios.
Investors generally find it ideal to invest in growing companies just as they begin to reap the benefits from their economic moat. The most important factor is longevity, as the wider and more sustainable the moat, the greater the benefits for the company and its shareholders.
The most obvious financial characteristics of a company with a wide economic moat are that they usually generate large amounts of free cash flow and have a track record of strong returns.
In addition to these characteristics, Stratosphere evaluates a company's historical profitability, the source of these profits, and the industry's competitive structure to determine the strength of their moat.
Learn more about the previously mentioned companies, how moats are identified, and much more by signing up to Stratosphere here, where we have a full breakdown on our top picks.