What is an economic moat?
An economic moat is a business’ ability to maintain its competitive advantages and fend off competition in order to protect its long-term profits and market share.
In the same way a moat provides a level of protection for the castle it surrounds, an economic moat refers to the level of defense a business has built to protect itself from competitors. According to Morningstar, a business may have a narrow moat or a wide moat, or no moat at all.
What is moat investing?
Moat investing is investing in companies that have sustainable competitive advantages, known as a ‘moat’. Moat is a metaphor, the castle is the business and the moat is its competitive advantage: The wider the moat, the more sustainable the business' competitive advantages.
The moat investing concept is attributed to Warren Buffett. The Wall Street Journal reported in 2012 that “Warren Buffett has used the term 20 times since 1986 to describe his investment process in annual letters to Berkshire Hathaway shareholders.”
When investing, moat size matters. Companies with the widest moats have the potential to create value for longer periods of time. According to Buffett, “A good business is like a strong castle with a deep moat around it. I want sharks in the moat. I want it untouchable.“
What is a wide moat?
A company with a wide moat is considered to have a sustainable competitive advantage that will remain for at least twenty years1. This makes wide moat companies very attractive for investors as the company’s profits and market share are highly likely to be protected over the long term.
How to identify companies with moats
There are five sources of moats for companies1. Each company with a moat rating has at least one, if not two, of these moats.
Switching costs give a company pricing power by locking customers into its unique ecosystem. Beyond the expense of moving, they can also be measured by the effort, time, and psychological toll of switching to a competitor.
Though not always easy to quantify, intangible assets may include brand recognition, patents, and regulatory licenses. They may prevent competitors from duplicating products or allow a company to charge premium pricing.
A network effect is present when the value of a product or service grows as its user base expands. Each additional customer increases the product’s or service’s value exponentially.
Companies that are able to produce products or services at lower costs than competitors are often able to sell at the same price as competition and gather excess profit or have the option to undercut competition.
In a market limited in size, potential new competitors have little incentive to enter because doing so would lower the industry’s returns below the cost of capital.