What is a Soft Economic Moat
BREAKING DOWN Soft Economic Moat
Soft economic moats rely upon a company’s unique, intangible qualities to generate competitive advantage over competing firms. Investing guru Warren Buffett first described competitive advantage using the term economic moat, underscoring the defensive capability a company has when it can sustain higher profits than its competitors. In order for a competitor to become a significant threat, it would first need to breach the moat in some way.
Companies may derive competitive advantage in a number of different ways, involving both tangible and intangible assets. For example, moats built from tangible assets might include elements such as massive physical scale that reduces production and distribution costs, or superior access to low-cost sources of raw materials. Intangible elements might include efficient management practices, superior corporate culture, powerful brand loyalty or resources related to intellectual property. Soft economic moats rely predominately on intangibles, which can make them more difficult to quantify for competitors and analysts.
Types of Economic Moats
Investment analysis of economic moats tends to focus less on the tangible or intangible nature of their constituent elements and more upon the moat’s durability. The longer a firm holds a competitive advantage, the greater its profit margins compared to the competition. Firms with wider economic moats pose greater challenges to competitors looking to close the gap than firms with narrow economic moats. Investors seeking long-term profitable plays look for companies with a wide economic moat and a relatively low valuation.
The composition of an economic moat matters as well, however. While intangibles may be more difficult to quantify, they may also provide a more durable competitive advantage in cases where they present difficulties for competitors trying to copy them. The success of a major pharmaceutical company over the medium term may depend heavily upon intellectual property held in its research and development organization, for example. Likewise, Jack Welch’s implementation of Six Sigma at General Electric produced a substantial change in his company’s leadership culture, which many investors saw as a key competitive advantage for the firm between 1981 and 2001.
Common tangible economic moats may derive from cost advantages derived from scale, high switching costs, or other quantifiable elements. For example, large-scale retailers can often negotiate lower wholesale prices due to the sales volume they command. Companies capable of driving high switching costs for consumers, such as major cellular phone providers who lock customers into long-term contracts, also enjoy competitive advantages over market entrants without an established customer base.