On Economic Moats

10/26/20264 min read

The word "moat" means a deep, wide trench or ditch—usually filled with water—dug around a castle, fort, or medieval town to protect it from attack. Similarly economic moat is the trench filled with water or competitive advantage that protects the castle or the company from attacks from competitive forces.
The word "economic moat" has been popularized by Warren Buffett.

Buffett says " A truly great business must have an enduring "moat" that protects excellent returns on invested capital."

To quote Pat Dorsey from the Five Rules of Successful Stock Investing " In any competitive economy, capital invariably seeks the areas of highest expected return. As a result, the most profitable firms find themselves beset by competitors, which is why profits for most companies have a strong tendency over time to regress to the mean. This means that most highly profitable companies tend to become less profitable as other firms compete with them.

Economic moats allow a relatively small number of companies to retain above-average levels of profitability for many years, and these companies are often the most superior long-term investments. Longer periods of excess profitability lead, on average, to better long-term stock performance. "

Identifying economic moats is a critical part of investing process. In the book
100 Baggers, author Christopher Mayer writes " Companies that are more durable are more valuable. And moats make companies durable by keeping competitors out. A company with a moat can sustain high returns for longer than one without. That also means it can reinvest those profits at higher rates than competitors. As you’ve seen by now, this is an important part of the 100-bagger recipe."

If a company operates in an attractive industry with good returns, it will sooner or later attract attention of bigger players of other industries with excess capital to deploy.

Moat is one of the most important edge a company can possess which protects its business from getting disrupted by such new entrants ready to invest high capital.

Types of moats

Moat can be the brand power or reputation company has created over the years through its demonstrated results, investment in branding, promotion resulting in a higher product market share and a distinctive position of its brands in customer mindspace through proper positioning.

Or Moat can be in the form of some strategic assets company possesses- some proprietary technology ( like google's search engine) / patents ( in case of pharma companies patented drugs can be sold by the patent holder for fist few years before it is allowed to sell by competitors) /some assets ( like a steel manufacturer having captive iron ore mine)/ license ( like 4G, 5G spectrum license for telecom players).

Moat can be extensive distribution reach/franchisee strength throughout the country deepened and strengthened by further layers , which cannot be replicated by a new company even after trying for years.

Moat can be long term contracts/ relationships/ exclusive rights enjoyed with OEs in case of B2B Supplier companies strengthened by technological edge of products.

Moat can be internal structures , operational excellence and intricate relationships across the entire network of different functions of the company encompassing suppliers, customers.

Moat can be network effects- where bigger gets bigger and top 1-3 players eventually sweep entire market, for new age platform businesses. Think about facebook- how people stopped using other networking sites as it got bigger and added more features, and killed competition by acquiring competing networks like whatsapp, instagram.

Switching costs is another form of moat. Think of a stockbroker, you won't easily change a stockbroker or if you are a Tally or SAP customer for your accounts, you won't easily change them.

Being the lowest cost producer is another moat. Think of Walmart as the lowest cost producer with "everyday low prices" strategy.

Identifying whether a company has a distinctive moat becomes one of the focal point of choosing a company while investing.

In his own words, Warren Buffett speaks on economic moats as follows

Economics of the moat and the castle

But the most important thing you can — you know, what we’re trying to do is we’re trying to find a business with a wide and long-lasting moat around it, surround — protecting a terrific economic castle with an honest lord in charge of the castle.

And in essence, that’s what business is all about. I mean, you want to be the lord of the castle, yourself. In which case, you don’t worry about that last factor. But what you’re trying to — what we’re trying to find is a business that, for one reason or another — it can be because it’s the low-cost producer in some area, it can be because it has a natural franchise because of surface capabilities, it could be because of its position in the consumers’ mind, it can be because of a technological advantage, or any kind of reason at all, that it has this moat around it.

And then our — then what we have to decide is — all moats are subject to attack in a capitalistic system, so everybody is going to try and — if you’ve got a big castle in there, people are going to be trying to figure out how to get to it.

But we are trying to figure out what is keeping — 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?

And then if we feel good about the moat, then we try to figure out whether, you know, the lord is going to try to take it all for himself, whether he’s likely to do something stupid with the proceeds, et cetera. But that’s the way we look at businesses.

On Economic Moats

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