What is an economic moat?

The term economic moat, popularized by Warren Buffett, refers to a business' ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms. Just like a medieval castle, the moat serves to protect those inside the fortress and their riches from outsiders.

Remember that a competitive advantage is essentially any factor that allows a company to provide a good or service that is similar to those offered by its competitors and, at the same time, outperform those competitors in profits. A good example of a competitive advantage would be a low-cost advantage, such as cheap access to raw materials. Very successful investors such as Buffett have been adept at finding companies with solid economic moats but relatively low share prices . (To read more, see Competitive Advantage Counts.)

One of the basic tenets of modern economics, however, is that, given time, competition will erode any competitive advantages enjoyed by a firm. This effect occurs because once a firm establishes competitive advantages, its superior operations generate boosted profits for itself, thus providing a strong incentive for competing firms to duplicate the methods of the leading firm or find even better operating methods. (For further reading, check out the Economics Basics Tutorial.)

Let's return to the example of a low-cost advantage. Suppose you have decided to make your fortune by running a lemonade stand. You realize that if you buy your lemons in bulk once a week instead of every morning, you can reduce your expenses by 30%, allowing you to undercut the prices of competing lemonade stands. Your low prices lead to an increase in the number of customers buying lemonade from you (and not from your competitors). As a result, you see an increase in profits. However, it probably wouldn't take very long for your competitors to notice your method and employ it themselves. Therefore, in a short period of time, your large profits would erode, and the local lemonade industry would return to normal conditions again.

However, suppose you develop and patent a juicing technology that allows you to get 30% more juice out of the average lemon. This would have the same effect of reducing your average cost per glass of lemonade. This time, your competitors will have no way of duplicating your methods, as your competitive advantage is protected by your patent. In this example, your economic moat is the patent that you hold on your proprietary technology. In this case, if your lemonade company was a public firm, your common stock would probably outperform that of your competition in the long run.

As you can see, a company's economic moat represents a qualitative measurement of its ability to keep competitors at bay for an extended period of time. This translates into prolonged profits in the future. Economic moats are difficult to express quantitatively because they have no obvious dollar value, but are a vital qualitative factor in a company's long-term success or failure and in the selection of stocks.

There are several ways in which a company creates an economic moat that allows it to have a significant advantage over its competitors. Below, we will explore some different ways in which moats are created.

Cost Advantage: As discussed in the lemonade stand example, a cost advantage that competitors cannot replicate can be a very effective economic moat. Companies with significant cost advantages can undercut the prices of any competitor that attempts to move into their industry, either forcing the competitor to leave the industry or at least impeding its growth. Companies with sustainable cost advantages can maintain a very large market share of their industry by squeezing out any new competitors who try to move in.

Size Advantage: Being big can sometimes, in itself, create an economic moat for a company. At a certain size, a firm achieves economies of scale. This is when more units of a good or service can be produced on a larger scale with lower input costs. This reduces overhead costs in areas such as financing, advertising, production, etc. Large companies that compete in a given industry tend to dominate the core market share of that industry, while smaller players are forced to either leave the industry or occupy smaller "niche" roles.

High Switching Costs: Being the big fish in the pond has other advantages. When a company is able to establish itself in an industry, suppliers and customers can be subject to high switching costs should they choose to do business with a new competitor. Competitors have a very difficult time taking market share away from the industry leader because of these cumbersome switching costs.

Intangibles: Another type of economic moat can be created through a firm's intangible assets, which includes items such as patents, brand recognition, government licenses and others. Strong brand name recognition allows these types of companies to charge a premium for their products over other competitors' goods, which boosts profits.

Soft Moats: Some of the reasons a company might have an economic moat are more difficult to identify. For example, soft moats may be created by exceptional management or a unique corporate culture. While difficult to describe, a unique leadership and corporate environment may partially contribute to a corporation's prolonged economic success. 

Economic moats are generally difficult to pinpoint at the time they are being created. Their effects are much more easily observed in hindsight once a company has risen to great heights.

From an investor's view, it is ideal to invest in growing companies just as they begin to reap the benefits of a wide and sustainable economic moat. In this case, the most important factor is the longevity of the moat. The longer a company can harvest profits, the greater the benefits for itself and its shareholders