One of the most essential components of Warren Buffett’s investing strategy is what he calls economic moats. It means a company’s competitive advantage that allows it to earn outsized profit for a long term.
In this article, we will understand what economic moat is and how it helps a company to have a competitive advantage over its competitors.
There are companies that produce above average returns for years despite economic downturn and competition. Such companies are said to possess “economic moats”.
Value and growth investors are always interested to invest in those companies that will be able to stay one step ahead of their competitors. It’s the strength and sustainability of a firm’s competitive advantage.
Keeping competitors at bay and staying ahead is essential in maintaining market superiority.
What is economic moat?
Economic moat refers to a company’s ability to remain competitive over its peers in order to maintain its long term profit and market share. It’s the ability to maintain the competitive edge over its competitors.
The term ‘moat’ indicates an edge a company has over its market competitors.
Economic moat separates the company from its competitors. Economies of scale, brand, intellectual property, network effect and regulation can contribute to economic moats.
Competitive edge allows a company to provide the same or better product or services at a low cost or better quality. Competitive advantage or edge is any quality that protects the company’s long term profits.
Examples of economic moat
As discussed above, the term “economic moat” became popular by Warren Buffett, the chairman of Berkshire Hathaway Inc. He used the term to describe a company’s competitive advantage.
Here are some examples of economic moats or a competitive advantage of a company to remain profitable in long term;
- Cheap access to raw materials.
- Low-cost advantage that competitors cannot replicate. Low operating costs helps the company to undercut its competition by lowering prices or with attractive offers to keep rivals at bay.
- Competitive advantage is protected by patents.
- Size advantage.
- Intangible assets such as brands, regulatory licenses and others that can prevent competitors from duplicating a company’s products. This will allow the company to charge a significant price premium.
- Enjoying a lower cost of capital that allows borrowing money for new investments.
- Advantage of network effect. The company will have a good network effect when more people use and recommend it.
- Switching cost: Switching costs are the costs a customer might incur as a result of switching brands or products. Customers and suppliers might not be interested to change or switch the company or its products if the move will incur monetary costs and time delays.
- The company has a natural monopoly due to few rivals in the market.
A narrow economic moat means the company has only a slim advantage over its competitors from the same industry segment. You will find narrow economic moats in a highly competitive industry.
A wide economic moat means the company has a large advantage over its competitors from the same industry segment.
Finding the economic moat of a company is not enough for investment. You need to do a complete fundamental analysis before investing. The present economic moat must translate into strong financials. Make sure that you have not overpaid for the stock.
