We all know what a moat is and what it does. It is a deep and broad ditch filled with water that acts as a preliminary line of defence to a castle or a town. In other words, it keeps invaders out. Using that very analogy, Warren Buffett coined and popularised the term economic moat, which refers to a barrier that protects a company from competition.
Let’s say a firm is doing very well and generating high profits. Naturally, this would result in competition because capital flows to the areas of highest potential return. High profits attracts competition and competition reduces profitability. The firms that stay profitable for a long time manage to do so by creating economic moats.
An economic moat is a structural business characteristic that allows a firm to generate high returns on capital for an extended period. It acts as a barrier that protects a company from competition.
An economic moat comes in many forms.
The network effect occurs when the value of a company’s service increases for both new and existing users as more people use the service. This is a potentially potent source of competitive advantage, and often applies to the first mover in an emerging technology.
Take a payment network like Visa. A visa card payment is accepted because it is the card that consumers have in their wallets. And why do they carry around those particular cards? Well, that's what's accepted as payment. It’s a virtuous network. Every person that takes out another Visa credit card is adding to that network and making it more likely that the merchants are going to sign up for Visa.
Intangible assets generally refer to the intellectual property that firms use to prevent other companies from duplicating a good or service. Patents in the pharmaceutical industry are the most common economic moat in this category. Copyrights, regulatory licenses, and governmental approvals also fall in this category. A strong brand name such as Coke or Tiffany can also be an economic moat.
When a niche market is effectively served by one or a small handful of companies, efficient scale may be present. When you have a company that's providing a service to a limited market, and there's a relatively small number of competitors supplying to that market, it may not make sense for a new competitor to enter the market, because that new competitor would destroy the returns for all the players involved.
The Sydney Airport stock is a case in point. The company develops and maintains the airport infrastructure and leases terminal space to airlines and retailers at the airport at Sydney, Australia. Sydney Airport’s regional monopoly, encompassing Australia's most populous city, creates a narrow economic moat.
Firms that can figure out ways to provide a good or service at a relatively low cost have an advantage because they can undercut their rivals on price. This means that you can either charge the same price as the other competitors out there, and reap a higher profit margin, or can charge slightly lower prices and maybe try and gain some share from competitors. For instance, Morningstar analysts believe Coal India Ltd enjoys a narrow moat, reflecting the significant cost advantage afforded by vast and relatively shallow open-cut coal mines.
High switching costs make it tough for your customers to use a competitor. The typical example is bank deposits. Those deposits tend not to turn over a whole lot simply because it costs customers time and effort to actually switch banks.
Investors should attempt to focus on wide and narrow moat companies when formulating their portfolio. It really helps sort out companies that may not be around in the long term or may not earn those returns that you are looking for as an investor.
Wide moat companies are very hard to attain and very few companies globally have a wide moat rating. Generally, analysts expect a wide moat company to earn excess returns for the next 20 years or so. Companies with a narrow moat are those that should earn excess returns for the next 10 years or so. The vast majority of companies have no moat. So even if they are earning excess returns now, it is not wise to expect them to persist long into the future.
While it makes for an excellent investment strategy, investing in a wide or narrow moat company is no guarantee to success. Valuation does play a very critical role. So don’t over pay for quality companies. Buying them when they are trading at a discount to their fair value is a really important consideration.
