What is an Economic Moat?

An economic moat is like a protective wall around a city…

If invaders want to attack a city and take it over, they first have to find a way to get into the city. If the city is surrounded by high walls, the invaders have to spend time climbing the walls or breaking through them, which gives the city time to defend itself. Similarly, a business with an economic moat has a great advantage over competitors, and often means it could be costly or time-intensive for competitors to take their market share.

An economic moat is a kind of advantage that a company has over its competitors. Economic moats can often be long-term advantages that may be difficult for other firms to emulate or compete against. Investor Warren Buffet is often credited for the term, which likens a company’s great advantage to a moat built around a medieval city, to defend it from attack.

A company with an economic moat has an opportunity to earn far greater profits or market share than their competition. The advantage can take different forms — Think of a company’s proprietary software, a brand with loyal customers, or a top-secret recipe. An economic moat also gives a company more time to respond to challenges by competitors, because it takes competitors time to find a way to overcome the moat. Investors care about economic moats because businesses that have long-term advantages can be difficult to surmount — And may offer better returns or greater stability.

Intangible assets, like branding, customer loyalty, and patents, could all be considered economic moats. Think of a widely recognized brand like Coca-Cola, for example. If a competing company wanted to market a similar soft drink, Coca-Cola would have a major advantage because of customer familiarity with its brand. A patent gives a company exclusive rights to a process or formula for creating a product. A pharmaceutical company might use a patent to create a moat — That way, competitors would either need to pay for the right to produce the same drug, or invest time and money to research and test a new one.

If there are high switching costs (the cost of changing from one vendor to another) in an industry, that can give established corporations a powerful economic moat. Take a popular design software like Adobe’s Photoshop, for example. A firm that wants to switch from Photoshop to a different program may have to train its staff on the new software or reduce its potential hiring pool to candidates familiar with the new program. That may give Adobe an advantage when setting prices or protecting its market share.

Economies of scale (where per unit costs go down as the units produced go up) can produce an economic moat for large, established businesses. Think of a utility company. Building a new electric grid or internet infrastructure can be costly for a city, but an established firm that already has the infrastructure may only need to pay for upkeep. To compete, a new utility company would have to invest a significant amount of money to provide similar services.

Companies with a cost advantage (the ability to set prices with their suppliers) also have an economic moat. Large businesses have more power to negotiate with their suppliers and can pay lower prices for the same goods that a smaller competitor also needs. That allows a firm with a cost advantage to charge lower prices than the competition, while still producing a profit.

A moat rating is an analysis of a company’s economic moat — How effective it is at a given moment, and for how long the moat will remain effective. A moat can be “wide,” meaning it’s expected to last for at least the next twenty years, or “narrow,” meaning it could last for about a decade. Each person or investment firm analyzing a company’s moat sets its own breakpoints for assigning ratings. The effectiveness and longevity of a moat can change with time. A moat rating can factor in whether the moat is gaining or losing effectiveness and longevity. Moat ratings often include a positive, negative, or neutral outlook to describe expected future changes to the moat.

The width of an economic moat is a way to describe the effectiveness and expected longevity of the moat. Just as it’s difficult to cross a wide moat to enter a city, it’s difficult for a business to cross a wide moat and overcome another firm’s competitive advantage. A business that has a narrow economic moat typically means that the company has some competitive advantages over other firms, but ones that are either surmountable or aren’t expected to last for a very long time. A company with a wide economic moat has major advantages over other businesses in their industry. In general, a company with a wide economic moat means that analysts expect other companies in the industry may have a very difficult time either entering or competing in the market, and that the moat could last for a long time to come.

There are multiple sources of economic moats. Here are some examples:

• Network effect: This describes companies where the value of its products or services increase as more people adopt the product. Prime examples of this are social media websites that rely on a large number of users, or websites that facilitate sales of goods between people.
• Intangible assets: Intangible assets like brand loyalty or patents, can produce an economic moat. Competing firms may have to invest significant money or time to license patents or produce new patents of their own. They may also have to spend resources coming up with their own branding and marketing, to try and overcome the established firm.
• Cost advantage: In which an established firm has more negotiating power and commands lower prices from suppliers — also helps a company build a moat. It lets the firm charge less for the same goods while still earning a profit.
• Switching costs: A business may have an advantage if its competitors have a large sunk cost and would need to spend a large sum to change suppliers.
• Efficient scales: If one or a few businesses serve a market effectively, satisfying all customers, it can be difficult or expensive for a new firm to enter the market. Even if they did, the potential profit may not justify the cost.

There isn’t a mathematical formula for calculating a company’s economic moat. Instead, stock analysts need to look at a business’s financial reports and consider other relevant information about the firm and its competitors to determine the size and effectiveness of its moat. One example factor is the company’s past financial performance. Businesses that perform well and provide a good return on investment can be good candidates for having an economic moat.

Another factor to consider is the strength of a company’s current performance. Is the company leveraging something that creates a moat, like a service that gets more useful as more people use it (aka a network effect), or a popular brand (aka intangible asset)? Or is the firm simply succeeding in the short-term due to good management or other reasons?

An analyst might also consider how long the moat will remain effective. Often, moats based on a new technology may not last long, because technology is always evolving. By contrast, moats created by network effects or efficient scales (operating in a market where only a few firms meet the demand) may last longer.

Having an economic moat gives a firm a significant advantage over its competitors. By definition, a moat makes it difficult for a firm to enter a market and compete with the established business. Depending on the source of the moat, the established company might rely on advantages like the ability to pay lower costs than competitors, charge higher prices, or retain loyal customers who are unwilling to change to a different product.

There isn’t a single way to identify a business with a wide moat, but there are a few indicators. For example, is the company an established business with a household name? A large, long-lived company probably has some form of an advantage that has helped it survive for so long. Think of a company like Coca-Cola, which has been around since 1886 and has become one of the largest, most recognized beverage companies in the world. Its branding has likely generated an economic moat that makes it hard for challengers to compete. The company also owns a number of other brands, like Fanta and Sprite, widening its appeal to a variety of consumer tastes.

Outside of brand recognition, financial reports can also offer clues. Firms that have steady or improving returns probably have an economic moat. It may also help to consider factors that give a business its moat. Things like branding, network effects, and switching costs tend to produce longer-lasting moats than something like a cutting-edge technology or a soon-to-expire patent.