What is Economic Moat?

This term was popularised by the legendary investor, Warren Buffet. When he was asked, what are the key indicators he looks for in the companies, before making an investment?

He replied, “I look for something that does give them a moat around it (the company)”. 

Excerpt from the documentary, Becoming Warren Buffet by HBO. Watch it by clicking here

Let’s begin with understanding, what does a moat mean. A moat is a deep wide trench built around the fortified place (fort or a castle). In the medieval period, moats were built around the castle and these moats were filled with waters and crocodiles were put in them in order to protect those inside the fort and their riches from the outsiders. 

In the business world, moat refers to the ability of a business to maintain competitive edge over its competitors. Economic moat helps the business to protect its riches (profits and market share) from the enemies (competing firms). It is very important for all active investors to understand this concept and identify moats in the market. Understanding moats is simple and easy but finding moats may not be as easy as it may seem. 

As per the basic principles of modern economics, no moat can exist forever. So, a good sustainable business should consistently build moats around its business. There are several ways in which a business can create an economic moat. Below, I am writing some of the most popular ways to create an economic moat:

• Better Operating Efficiency: Businesses with higher operating efficiency would have higher profits even when two companies sell the same number of units. Most of the businesses achieve this with economies of scale or with the help of better technology
• Brand and other intangible assets: With a strong brand name, businesses are allowed to charge a premium on their products which increase profit margin. Other intangible assets such as goodwill, patents, government licenses can be used to create a moat. For example, in the Pharma sector, if one company has a patented drug for some disease and no other company produces any cure for that disease, the company had successfully built a moat around it
• Soft Moats: It may be created with exceptional management and talented work-force. It might be difficult to describe the impact, unique culture and effective leadership definitely boost the morale and productivity

Power of Moat: 

The market Capitalisation of Toyota (Listed on NYSE) is more than 5-times than the market capitalisation of Ford (Listed on NYSE) even when the number of cars sold by Toyota is little less than the number of cars sold by Ford. It is only because Toyota has built a moat with higher operating efficiency. 

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