Economic Moat

What is an Economic Moat?

An economic moat is a company's long term and sustainable competitive advantage that enables it to protect profits and market share from competing firms. 

Economic Moat

There are several ways a company can create an economic moat in the marketplace allowing it to gain a significant level of advantage over its competitors:

How businesses can achieve an economic moat?

A business with an economic moat establishes a long term competitive advantage with the intention of securing profitability and market share. It can be difficult for a company to cross the threshold of profitability and just as difficult to hold on to it, that is why it is vital for every business to secure a leg up within their industry. 

Competitive advantages come in a variety of forms, the most important being cost advantage, intangible asset advantage, scale effect, network effect, and switching costs. If a company is able to acquire one or more of these advantages, it may stand a chance at warring off competition and preserving market share. 

Businesses that are unable to preserve dominance within an industry risk losing market share and may eventually begin to see a decline in revenue. Great examples of companies that were unable to maintain a competitive advantage include: 

  • Myspace: overtaken by Facebook
  • AOL: lost market share to Google
  • Blockbuster: replaced by Comcast On Demand and then Netflix
  • Blackberry: cell phone lost prominence to the Apple iPhone

Any company must constantly be on the lookout for potential pitfalls. Management teams are constantly running SWOT analysis in order to prevent declines in profitability. SWOT stands for Strengths, Weaknesses, Opportunities, and Threats. It is essential for any business to perpetually self-reflect and innovate. 

  • Strengths: advantages a company has over competition 
  • Weaknesses: areas in which a company is lacking and needs to improve 
  • Opportunities: potential factors in the external environment that a company could use to advance 
  • Threats: potential competition and exterior risks that could hurt a company

In order for any business to grow and develop within a marketplace, first it must acquire an advantage. A reason for why customers will choose you over the competition. This advantage must be enhanced continuously in order to acquire a long term defendable primacy within a sector. 

Cost Advantage:

When a company can produce a product or service at a lower price than its competitors. 

Businesses who acquire a cost advantage do so by having:

  • Easy access to raw materials
  • Dynamic operational procedures
  • Low selling costs 
  • Advanced technologies

Companies that supply or manufacture their goods or services at a low cost have a great advantage as they can outperform their competitors on price. If this advantage is long term, a business can control and retain a large market share in their industry. In addition, with significant price advantages a company can offer lower prices than any competitor trying to enter their industry, this can force a competitor to leave the industry, or at the very least hinder the competition's growth. 

If there is a large gap between the revenues of one company and its competitor, you might say that the most profitable company has a large moat. For example, Apple is said to have a wide moat because the sales for its iPhone far outnumber the sales of any other smartphone on the market. 

Companies with a cost advantage have two opportunities they can choose from:

  1. Offer the same prices as their competitors and increase net income due to expenses being lower.
  2. Offer lower prices than their competitors and take over more of the market. 

Intangible Asset Advantage:

Prevents competitors from replicating a business's products or services. Sometimes this can result in cornering the market via a distinct/unique product, or can result from a more loyal customer base via brand name recognition. 

For example, with a pharmaceutical company, intangible assets play a huge role in determining their product condition, this includes brands, acquired brands, research and development, design, technical know-how, licensing, etc. 

Brand-based corporate moats protect a company from competition through a kind of unique value proposition. Intangible assets can allow a company to gather more market share and if desired charge a higher price for products and services. 

Pat Dorsey, author of

, argues that effective brands change consumer behavior by increasing our willingness to pay for something or lowering our search costs.

Bayer

                                                                                                            Image from CNN

Intangible Asset Examples:

  • Patents
  • Brands
  • Regulatory Licenses

Scale Effect:

Cost advantages that derive from economies of scale. When a company increases the amount of production and becomes larger, sometimes it can lead to a company becoming more efficient. This efficiency results in lower costs. There are two types of scale effects that can impact a businesses profitability, one being external and the other internal. 

External: factors outside company control. strong man diagram for scale effect

  • Tax Reductions
  • High Skilled Labor
  • Efficient Transportation 
  • Government Subsidies

Internal: factors within company control.

  • Bulk Purchases
  • Acquisitions of Advanced Technology 
  • Attractive Debt Financing

Network Effect:

A network effect occurs when more and more customers use a given product or service. Asinstagram for network effect involvement increases, the product or service increases in value. This increase in value makes it difficult for competitors to offer alternatives because despite being able to offer a substitute, the substitute lacks a strong network.

A great example of this phenomenon could be Instagram. Despite many companies being able to offer alternative social media applications, the network within the application lacks millions of people interacting with each other. 

Switching Cost:

Switching costs allow companies to maintain customers through making it difficult to begin using an alternative product or service. Difficulty can come in the form of high fees, being forced to learn new skills, or a lack of integration between a base product and various sub products that can be consumed via the base product. 

medical device for switching costs

  • Base Product: A company may sell the customer a product that allows further purchases to be made such as a computer or smartphone. The product cant be integrated with any software or applications that are made by competitors forcing the customer to exclusively shop in house. (example: Apple's IOS mobile apps that cannot be accessed on Android smartphones) 
  • High Fees: A company makes it expensive to switch over to a competitor. These fees may come about when terminating an account or breaking a contract/subscription. 
  • Learning Curve: If someone is trained to operate a specific technology be it a healthcare professional with a specific medical device or an administrative assistant using a specific computer software, learning new skills takes time and effort. This sacrifice in time and effort can act as a disincentive for switching over to a product made by another company.  

What is a competitive advantage?

Michael Porter, a professor at Harvard Business School, wrote a book in 1985 called The Competitive Advantage: Creating and Sustaining Superior Performance. It identified three strategies that businesses can use to tackle competition. These approaches can be applied to all businesses whether they are product-based or service-based. He called these approaches generic strategies. They include cost leadership, differentiation, and focus. These strategies are used to gain or improve upon a competitive advantage.michael porter book

  • Cost Leadership: Occurs when a business sets out with the intention of becoming a low cost producer within an industry. This transformation may occur through economies of scale, access to raw materials, or superior technology. A key factor in developing cost leadership is the ability to create a product with lower costs without sacrificing quality. The quality of the product must be on par with competitors.
  • Differentiation: Occurs when a business pursues becoming unique within an industry. The company selects attributes that are underrepresented by producers within a sector and that are highly appreciated by the target customer base. Unique attributes can vary from a specific product, to the delivery of a product, to the technology a company implements. This kind of differentiation amongst competitors allows a company to sell products for a premium. 
  • Focus: Occurs when a company sets its sights on serving a niche customer base. It is an attempt to provide a product or service that is more personalized and specific to a distinct group of consumers. This advantage offers an opportunity to create a more satisfied clientele. Customers may be willing to pay a premium for a tailored service or product opposed to doing business with a company that covers a broader market. 

Michael Porter's Five Competitive Forces

  1. Competition between rival businesses: A company is at a disadvantage when there is a large amount of competition. The more competition, the more customers can shop around for similar products and services provided by other companies. Little competition in an industry allows a company to have more power via consumers having less options to explore alternatives.
  1. Supplier bargaining power: If an industry has few suppliers, these suppliers can raise prices on materials needed for the manufacturing of goods. These rising costs lead to higher expenses and lower margins. When an industry has a large number of suppliers, a company has more options to alternate between suppliers who offer the lowest price, leading to lower expenses and higher margins. 
  1. New competitors: If entry costs are high and require a large amount of time and effort, it can act as a barrier to entry for competition. Meanwhile if entry costs are low and the entry process can be accomplished within a short time frame, it can create an environment in which competition can more easily enter into the marketplace. 
  1. Substitute Products/Services: If a company produces a product that can be easily replicated by competitors, customers can more easily shop around for lower prices. When a company has a product that is unique and cannot be substituted for, it allows the company to have more control over their market share and potentially even raise prices. 

michael porter diagram

Warren Buffet's investment strategy 

The economic moat is a term used to describe a company's competitive advantage. Warren BuffettWarren Buffet renowned investor and CEO of Berkshire Hathaway, is credited for coming up with the term. The main importance of the economic moat, as explained by Warren Buffett, is to gain a competitive advantage over other businesses by having a brand, product, or service that is difficult to imitate. This kind of ascendancy creates a long-term advantage for the company to maintain and grow. 

Buffett's investment strategy focuses on companies with a strong economic moat because they are more likely to contend with competitors and remain successful over the long run. Here is a quote from the

, "So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business. And we tell our managers we want the moat widened every year. That doesn't necessarily mean the profit will be more this year than it was last year because it won't be sometimes. However, if the moat is widened every year, the business will do very well. When we see a moat that's tenuous in any way - it's just too risky. We don't know how to evaluate that. And, therefore, we leave it alone. We think that all of our businesses - or virtually all of our businesses - have pretty darned good moats."

Since coining the term, Warren Buffet has used the term consistently throughout annual shareholder letters and meetings. Below are a few examples.

  • "Why is that castle still standing? And what's going to keep it standing or cause it not to be standing five, 10, 20 years from now. What are the key factors? And how permanent are they? How much do they depend on the genius of the lord in the castle?" -
  • "GEICO's low costs create a moat – an enduring one – that competitors are unable to cross. As a result, the company gobbles up market share year after year, ending 2016 with about 12% of industry volume." - 2016 Berkshire Hathaway Annual Shareholder Letter
  • "We're trying to find a business with a wide and long-lasting moat around it, protecting a terrific economic castle with an honest lord in charge of the castle." - 1995 Berkshire Hathaway Annual Shareholder Meeting

Morningstar's economic moat rating 

Economic moats are difficult to quantify as they often comprise intangible factors within a business such as brand name and pricing power that have no obvious dollar value. Nonetheless, they are a vital qualitative factor when considering the long-term success or failure of a company.

The Morningstar Economic Moat Rating evaluates a company's structural competitive advantage that allows it to fend off competition and earn excess profits over a sustained period of time. Morningstar rates a company's economic moat on a scale between wide moat, narrow moat, and no moat. 

 

morningstar economic moat rating

                                                                                                    Image from Morningstar

 

Morningstar bases its economic moat ratings on the following five factors:

  1. Intangible assets such as patents, government licenses and brand recognition to charge premium prices.
  2. Switching costs that make it unattractive for customers to stop using a company's products.
  3. Network effects that increase the value of a good or service for both new and existing users as more people use that good or service.
  4. Cost advantages from producing goods or services at a lower cost, allowing the firm to undercut competitors or achieve higher profitability.
  5. Efficient scale associated with a competitive advantage in a niche market with few rivals. 

Here is an example of a Morningstar analyst report on Apple's economic moat:

  • "One of the keys to finding an excellent long-term investment is to buy a company that can be one step ahead of competitors, and this is the characteristic that Morningstar is trying to see as the strength and sustainability of a company's competitive advantage."
  • "A company whose competitive advantages we expect to last more than 20 years has a wide moat; one that can fend off their rivals for 10 years has a narrow moat; while a firm with either no advantage or one that we think will quickly dissipate has no moat."

A 21st Century Competitive Advantage: 

As technology increasingly integrates with our daily lives, it has allowed various companies to acquire massive amounts of data. Through building large data sets based upon customer purchases, social network interactions, and personal information voluntarily offered by customers, data can be used as feedback for enhancing products, predicting consumer behavior, and analyzing industry trends. 

Data enabled learning products that instantly adapt to customer information and offer tailored services/products for each individual have allowed companies to gain an edge on their competition. 

A great example of this is the social media application Tik Tok which creates a custom algorithm for each account based on the individual's interactions with content. Or think about Amazon, every purchase a customer makes gives Amazon more information about what the customer values, this allows for product recommendations to increase in accuracy. 

This new advantage has been termed by some as "competitive intelligence" or "corporate intelligence". 

Data driven organizations are:

  • 23x more likely to acquire customers 
  • 19x more likely to be profitable 
  • 6x more likely to retain customers (according to Mckinsey Global Institute)
  • 56% of business executives use competitive intelligence to monitor competition and plan for entrances into new markets (according to PricewaterhouseCoopers)
  • In 2006 British mathematician Clive Humby stated "Data is the new oil". And in 2017 The Economist published an article entitled, "The world's most valuable resource is no longer oil, but data."

A data driven competitive advantage is somewhat intertwined with the network effect. With a network effect, the more customers consume a product the better the product becomes. Likewise with data, the more customers who use a company's platform, the more data that can be used for analysis. This analysis allows a company to be able to create a higher quality product, which in turn leads to more customers. 

data circle diagram

Examples of companies and their economic moats 

Google

Founded in 1998 by Larry Page and Sergey Brin while they were attending Stanford University. Page and Brin developed a search engine called PageRank that assessed the importance of a website based upon how many other sites had linked their pages to the website in question. Prior to PageRank, most search engines prioritized websiteGoogle Founderss based upon their use of specific keywords. 

This revolution led to Google becoming the dominant search engine with 5.6 billion searches taking place every day (Microsoft's Bing is the second most popular with 900 million searches per day). Google uses all of the data acquired through searches as feedback for improving its search engine. 

They also use data to improve systems for their other products such as Google Maps. Google Maps assesses real time traffic based upon data from people who are using the app, after analyzing this data Google can offer customers faster directions towards their desired destination. 

As this personalization process occurs, it allows Google to create a better product for customers and a more attractive platform for advertisers, while making it difficult for competitors who don't have access to the same plethora of information.  

Walmart

Founded in 1962 by Sam Walton, today Walmart is the largest company in the world based upon revenue withWalmart $559 billion a year. Walmart is a big box store that combines both aspects of a supermarket and a department store allowing it to offer a wide variety of products to its customers. 

What allowed Walmart to grow into the massive company it is today was exploiting the cost advantages derived from the use of regional networks. By having hundreds of stores within one region, it allowed Walmart to order in bulk and benefit from lower shipping/transportation costs, these factors allowed Walmart the opportunity to offer customers lower prices. 

An individual store has no bargaining power with suppliers, while an integrated network of stores do. 

IBM

Founded in 1911 by Charles Ranlett Flint and officially named IBM "International Business Machines" in 1924.IBM System 360 IBM produces and sells computer hardware and software. In the 1950s, there was no way to upgrade a computer's processing power or purchase a new computer without losing all of the data and software you had acquired. IBM changed this with the System 360, companies were now able to buy a computer and upgrade it without losing data and software. The System 360 made it difficult for companies to switch over to a competitor's computer, if they did make the switch they would have to part ways with all of the information and software they had acquired over the course of the business. With this development, IBM became the dominant manufacturer in the computer industry. 

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