Warren Buffett popularized the concept of an economic moat.
An economic moat refers to a competitive advantage that one company has over others in the same industry. Economic moat helps protect a company’s long-term profits and market share from competition.
Strong economic moats help to sustain a company’s market position over time and deliver consistent returns to shareholders.
Types of economic moats
There are several types of economic moats, each based on different mechanisms that create barriers to entry and give companies durable advantages in their respective industries.
Here are the main types of economic moats:
Cost Advantages
Cost advantage as an economic moat refers to a company’s ability to produce goods or services at a lower cost than its competitors. This helps the company to maintain a higher profit margin by charging market level prices.
Cost advantage helps to have a competitive advantage as the company can offer its products at a lower price than competitors. It can create a barrier as the competitor needs to reduce their prices to remain competitive, which can impact competitor’s profitability.
Walmart and IKEA have cost advantages over its competitors.
Brand Recognition
A company with strong brand recognition has established a trusted market share and familiar identity among customers. It helps the company to maintain price and customer loyalty.
Customers will always like to buy from a brand they recognize and trust, even if competitors offer similar products.
Brand helps the company to charge premium prices because consumers perceive branded products as being of higher quality, even if the actual difference in quality is minimal.
Apple, Nike, Starbucks and Rolex are perfect examples of Brand as an economic moat.
Network Effects
Network effect works when a product or service becomes more valuable as more people use it. When a platform or network has more users, the more attractive it becomes to new users, creating a barrier that is difficult for competitors to overcome.
Large networks help the company to dominate the market.
Perfect examples are Facebook, Instagram and Whatsapp. New users are interested to join facebook, Instagram and Whatsapp as their friends, followers and family members are already on the platform.
Intellectual Property
Intellectual property (IP) provides legal protections for its inventions, innovations, brands, or creative works. It helps the company to exclusively produce and profit from its intellectual assets. Competitors can not copy or replicate it.
IBM, Qualcomm, Apple, Microsoft, pharmaceutical companies like Pfizer and GSK, are filing patents globally for its technological innovations, which helps them to remain competitive in the market with a higher profit margin.
Intellectual property creates a powerful economic moat by legally preventing competitors from replicating a company’s products, processes, or creative works.
Regulatory Advantages
Regulatory Advantages refers to favorable government regulations, policies, or laws that create barriers for competitors. License and permit requirements create regulatory hurdles for new competitors.
Companies in industries with heavy regulation have a significant advantage over new entrants. Few countries have created regulatory frameworks to protect domestic companies from international competition.
Companies like Lockheed Martin, AT&T, HAL and Boeing are perfect examples having regulatory advantage as an economic moat.
Even pharmaceutical companies in the US benefit from FDA approvals and patent protections, which allow the pharma companies to be the sole producers of certain drugs for a set period.
High Switching Costs
High switching cost refers to the significant financial, time, effort, or psychological costs that a customer incurs when switching from one product or service to another.
Due to high cost barriers, companies retain their customer base and maintain market share.
Perfect example is the telecom industry.
SAP and Oracle are two other companies which fall into this category as switching to a different ERP system from the existing one is not only expensive but also requires re-integration of many business processes.
This type of economic moat helps companies to sustain over the long term and remain competitive over a period of time. Economic moat also prevents rivals from easily encroaching on their market share.
