What Is a Wide Economic Moat?
A wide economic moat is a type of sustainable competitive advantage possessed by a business that makes it difficult for rivals to wear down its market share. The term economic moat was made popular by the investor Warren Buffett and is derived from the water-filled moats that surrounded medieval castles. The wider the moat, the more difficult it would be for an invader to reach the castle.
A wide economic moat can be caused by several factors that might make it difficult for other businesses to steal market share. These factors may include high barriers to industry entry, or the business with the moat might own patents on several products that are essential to providing their particular product or service.
- An economic moat is a distinct advantage a company has over its competitors that allows it to protect its market share and profitability.
- A wide economic moat is one that is difficult to mimic or duplicate (e.g., brand identity, patents) and thus creates an effective barrier against competition from other firms.
- Companies with a wide economic moat have are able to generate large amounts of free cash flow and have a track record of strong returns.
Understanding a Wide 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.
Businesses that possess at least one factor of Porter's 5 forces model would possess a wide economic moat. For example, a business that holds an exclusive patent for the creation of a miracle drug would effectively keep potential competitors out of its business. Having few or no competitors would allow the company to continually generate high levels of profit.
A company that exists in a business where the start-up costs are prohibitive for small entrants would also have a wide moat. There are several ways in which a company creates an economic moat that allows it to have a significant advantage over its competitors.
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. 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-how 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 an 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 are another type of economic moat, which makes 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 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 more valuable the more people use them. An example of a network effect is online marketplaces such as Amazon and eBay, which are widely popular among consumers because of the large number of people buying and selling various products through their platforms.