What Is a Narrow Economic Moat?
A narrow economic moat is when a firm commands only a slight competitive advantage over competing firms operating in the same or similar type of industry. A narrow economic moat is still an advantage for a company, but it is one that only provides a limited amount of economic benefit and will typically last for only a relatively short period of time before competition marginalizes its importance.
A narrow moat can be contrasted with a wide economic moat.
- A narrow economic moat refers to a company with only a slim advantage over its competitors in a given market or industry segment.
- An economic moat is a distinct advantage a company has over its competitors which allows it to protect its market share and profitability; sometimes companies have a wide economic moat, which means they have a large advantage over their competitors.
- Narrow moats exist in highly competitive sectors that have low barriers to entry and only a small ability to protect intellectual property.
Moat: My Favorite Financial Term
Understanding Narrow Moats
The term "narrow moat," originates from the phrase "economic moat," which was coined by legendary investor Warren Buffett. This phrase has since been refined to include both "wide moats" and "narrow moats."
A firm that exists in a highly competitive industry or one with tight profit margins may not be able to establish a high degree of competitive edge over its peers. Some industries may not allow for the protection of certain intellectual property rights which could otherwise be taken advantage of to expand a firm's economic moat. Economic sectors that have a low barrier to entry will also find achieving a wide moat to be difficult since new entrants can appear at any time and claim market share. Firms with narrow moats can still succeed and even thrive, but there is very small chance that they will achieve market dominance.
Wide economic moats, on the other hand, offer substantial economic benefits and are expected to endure for a prolonged period of time, while narrow moats offer more modest economic benefits and typically last for a shorter period of time.
Sources of Economic Moats
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. Patents are obtained when a company files a patent claim with the government. The claim protects information for a specific period of time, typically 20 years. Pharmaceutical companies earn high profits by patenting drugs, usually after spending billions on researching and developing the drug.
When a particular market is best served by a limited number of companies, those companies can achieve near-monopoly status (and a wide economic moat). Utility firms are a good example of this because it is necessary for them to serve electricity and water to all customers in a single geographic area. Building a second utility company in the same area would be too costly and inefficient.