What is Economic Moat?
An Economic Moat is the competitive advantage belonging to a particular business that protects its profit margins from competitors in the market and other external threats.
How Does an Economic Moat Work?
An economic moat refers to a company with a long-term, sustainable competitive advantage, which protects its profits from competitors and external threats.
If a business is said to have an economic moat, or “moat,” for short, then it has a differentiating factor enabling the company to hold a competitive edge.
In effect, the moat leads to sustainable profits over the long run and a more defensible market share, as the advantage cannot be easily mimicked by others.
Once companies capture a sizable percentage of a market, their priorities shift toward profit protection from outside threats such as new entrants.
What Benefits Do Economic Moats Provide?
The creation of an economic moat helps fend off competition – albeit, all companies are vulnerable to disruption to some extent.
In the absence of an economic moat, a company is at risk of losing market share to its competitors, particularly nowadays as software continues to disrupt all industries.
Any established company with a sizable market share, at some point in the future, must protect their profits and implement defensive strategies to retain their existing customers from external threats in the market, irrespective of how niche its product or service offerings are.
Hence, the necessity for companies to build a moat, which is essentially a mechanism to deter new developments in the industry and threats that pose a material risk to their long-term viability.
Simply put, moats in business refer to the unique, differentiating factors that cannot be easily replicated nor imitated by competitors.
In short, moats protect the market share and positioning of companies and facilitate the long-term sustainability of their business model, including the continued generation of profitability.
For instance, brand identity and reputation encourage customer loyalty, as seen in the case of Coca-Cola.
Warren Buffett Quote on “Moat”
Warren Buffett Quote (Source: Berkshire Hathaway 2007 Shareholder Letter)
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Enroll TodayNarrow vs. Wide Economic Moat: What is the Difference?
There are two different types of economic moats:
- Narrow Economic Moat → A narrow economic moat refers to a marginal competitive advantage over the rest of the market. While technically still representing an advantage, these sorts of moats tend to be short-lived.
- Wide Economic Moat → However, a wide economic moat, on the other hand, is a competitive advantage far more sustainable and difficult to compete with in terms of market share.
What are the Different Types of Moats in Business?
The common sources of economic moats include the following:
| Factor | Example |
|---|---|
| Network Effects |
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| Switching Costs |
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| Economies of Scale |
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| Intangible Assets |
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How to Identify an Economic Moat in Stocks
1. Unit Economics
The economic moat will be evident in a company’s unit economics in the form of consistent operational performance and profit margins on the high-end relative to the industry average.
Companies with economic moats more often than not have higher profit margins, which are a byproduct of favorable unit economics and a well-managed cost structure.
Thus, if a company has an economic moat, sustainable long-term value creation can be attained.
If a company consistently has a better margin profile than the rest of the market, then this is typically one of the first signs of an economic moat.
The most common measures of profitability are as follows.
| Profitability KPI | Formula |
|---|---|
| Gross Margin (%) |
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| Operating Margin (%) |
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| EBITDA Margin (%) |
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| Net Profit Margin (%) |
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| Basic Earnings Per Share (EPS) |
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| Diluted Earnings Per Share (EPS) |
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2. Value Proposition and Differentiation
Just because a company has high margins does not signify a moat, because there must also be an identifiable, unique advantage.
In other words, there must be a unique value proposition and/or a strong reason behind the durability of the future profits (e.g. cost advantages, patents, proprietary technology, network effects, branding).
Additionally, the factors should be very difficult to replicate by other competitors in the market and come with barriers to entry such as high switching costs or capital requirements (i.e. capital expenditures, or “Capex”).
3. Return on Invested Capital (ROIC)
The final KPI that we’ll discuss is the free cash flow (FCFs) of a company, which is directly tied to the company’s capacity to spend on growth and re-invest into its operations.
The more efficient a company can convert its operating cash flows into free cash flow (FCF) – i.e. FCF conversion and FCF yield – the more cash flows are available to use to obtain a higher return on invested capital (ROIC).
The creation of a long-term economic moat requires a company to find its own competitive edge, but also to recognize that its continued profit generation depends on constant adjustments to adapt to changing environments as new trends emerge (e.g. Microsoft).
As a general rule, the more defensible a company’s economic moat, the more challenging it becomes for existing competitors and new entrants to breach this barrier and steal market share.
What is an Real-Life Example of an Economic Moat?
Economic moats can be viewed as protective barriers against threats to the competitive positioning of companies, so stronger moats mean higher “hurdles” for the rest of the market.
For instance, Apple (AAPL) is a clear example of a company with an economic moat from various sources, but the one we’ll focus on here is its switching costs.
The more difficult it is to switch to a rival offering – either due to monetary reasons or convenience – the stronger the moat is around the incumbent, or, in this case, Apple.
For Apple, not only is it expensive for customers to switch to a different product offering, but it is difficult to escape the so-called “Apple Ecosystem”.
Apple Product Line (Source: Apple Store)
If a consumer has a MacBook, you can likely bet that the person also owns an iPhone and AirPods.
The more Apple products that you own, the more benefits you can derive from each product due to how compatible and well-integrated they are (i.e. “the whole is greater than the sum of the parts”).
Hence, the Apple product users tend to be some of the most loyal customers, which directly coincides with more long-term recurring revenue.
