A:

The term economic moat, coined and 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. 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 very 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%, making you able 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. 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, due to the ability of economic moats to protect excess profits and produce solid long-term returns, firms have a very strong incentive to find ways to establish economic moats, and investors have an equally strong incentive to determine which stocks have solid economic moats and which do not.

To learn more about this topic, read Warren Buffett: How He Does It, Bloodletting And Knights: A Medieval Guide To Investing and A Look At Economic Moats - Part 1 from the Investopedia Advisor.

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