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What is an 'Economic Moat'

An economic moat is a competitive advantage that one company has over other companies in the same industry; this term was coined by Warren Buffett, a renowned investor and executive at Berkshire Hathaway. The wider the moat, the larger and more sustainable the competitive advantage of a firm. By having a well-known brand name, pricing power and a large portion of market demand, a company with a wide moat possesses characteristics that act as barriers against other companies.

BREAKING DOWN 'Economic Moat'

Economic moat describes a company's competitive advantage derived as a result of various business tactics that allow it to earn above-average profits for a sustainable period of time. Companies that obtain defensible competitive advantage from patents, cutting-edge technologies and other cost advantages can have a wide economic moat that curbs competition within their industry. Also, firms that enjoy strong economic moat tend to demonstrate solid financial performance and rising returns on capital over time. The most common sources of economic moat are cost advantages, switching costs, efficient scale, intangible assets and network effects.

Sources of Economic Moat

A company that is able to maintain low operating expenses in relation to its sales compared to its peers has cost advantages, and it can undercut its competition by lowering prices and keeping rivals at bay. Consider Wal-Mart Stores Inc., which has an immense volume of sales and negotiates low prices with its suppliers, resulting in low-cost products in its stores that are hard to replicate by its competitors.

Intangible assets refer to the patents, brands and licenses that allow a company to protect its production process and charge premium prices. While brands are typically derived from superior product offerings and marketing, patents are obtained as a result of companies' filings with governments to protect know-hows for a specific period of time, typically 20 years. Pharmaceutical companies earn high profits due to patented drugs after spending billions on research and development.

Efficient scale arises when a particular market is best served by a limited number of companies, giving them near monopoly statuses. Utility firms are examples of companies with efficient scale that is necessary to serve electricity and water to their customers in a single geographic area. Building a second utility company in the same area would be too costly and inefficient.

Switching costs is another facet of an economic moat, which make it very time-consuming and expensive for consumers to switch products or brands. Autodesk Inc. offers various software solutions for engineers and designers that are very difficult to learn. Once an Autodesk's customer starts using its software, he is unlikely to switch, allowing Autodesk to charge premium prices for its products.

The network effect can further fortify a company's economic moat by making its products valuable the more people use them. An example of a network effect is online marketplaces such as Amazon.com and eBay, which are widely popular among consumers because of the large quantity of people buying and selling various products through the platforms.

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