Economic Moat overview

An economic moat refers to a sustainable competitive advantage that a company has over its competitors, which allows it to maintain its market share and profitability over an extended period.

A company with an economic moat can fend off competition, generate stable earnings, and maintain its pricing power. The term “economic moat” was popularized by Warren Buffett, who uses it as a key criterion for identifying high-quality businesses with long-term growth potential.

Warren Buffett, the legendary investor and chairman of Berkshire Hathaway, is widely credited with popularizing the concept of economic moats in investing. Buffett has defined an economic moat as a sustainable competitive advantage that allows a company to earn above-average profits over the long term.

According to Buffett, there are several types of economic moats that a company can have, including:

Broader view on Economic Moat types

Several types of economic moats can be identified:

  • Brand Power: A strong brand name can create a loyal customer base, which is difficult for competitors to break into.

  • Switching Costs: Companies can create high switching costs for customers, which means that it becomes expensive or time-consuming to switch to a competitor’s product or service.

  • Network Effects: In some industries, the value of a product or service increases as more people use it. This is known as a network effect, and it can create a significant barrier to entry for new competitors.

  • Cost Advantages: Companies can achieve a cost advantage through economies of scale, proprietary technology, or efficient production processes.

  • Regulatory Protection: Some companies benefit from regulatory protection that makes it difficult for competitors to enter the market.

  • Intangible asset moat: patents, licenses, or other intangible assets that protect a company’s intellectual property or technology

A company with a strong economic moat can enjoy several benefits, such as higher profit margins, lower risk, and greater pricing power. As a result, investors often look for companies with a sustainable competitive advantage when seeking long-term growth opportunities.

Who provides the economic moat information

There are several providers of economic moat information, including Morningstar, S&P Global Market Intelligence, and Valuentum Securities, among others. T

Morningstar, for example, uses a five-tiered system to rate a company’s economic moat, including Wide, Narrow, and No Moat, as well as a Negative and a Stable Moat Trend rating. S&P Global Market Intelligence uses a similar approach, with five categories ranging from Wide to None.

Valuentum Securities uses a proprietary approach that focuses on analyzing a company’s expected future cash flows to determine its economic moat. They assign moat ratings of None, Narrow, and Wide to companies based on their competitive advantages.

Measuring an economic moat

Measuring an economic moat can be a subjective process, and there is no standardized metric for doing so. However, there are several factors that investors and analysts consider when assessing the strength of a company’s economic moat.

  • Market Share: Companies with a high market share in a particular industry are often considered to have a strong economic moat. This is because they have established themselves as the dominant player in the market, making it difficult for competitors to gain traction.

  • Profitability: A company’s profitability is another indicator of its economic moat. If a company is consistently generating high profits, it suggests that it has a competitive advantage over its peers.

  • Return on Invested Capital (ROIC): ROIC measures how efficiently a company uses its capital to generate profits. Companies with a high ROIC are often considered to have a strong economic moat, as they are able to generate high returns despite the capital they invest.

  • Brand Power: The strength of a company’s brand can be a significant indicator of its economic moat. A well-known brand can create a loyal customer base, which can be difficult for competitors to break into.

  • Switching Costs: Usually those are easy to identify and even quantify.

Examples of Switching Costs

Enterprise resource planning (ERP) systems can be extremely costly and time-consuming to switch to a different system. This is because the company has invested a significant amount of money, time, and resources into implementing the original system and customizing it to fit their specific needs. In addition, switching to a new system would require re-training employees on how to use the new software, which can also be a costly and time-consuming process.

Examples of enterprise software systems with high switching costs include SAP, Oracle, and Microsoft Dynamics. These companies have established themselves as leaders in the enterprise software market, and their customers are unlikely to switch to a competing system due to the high switching costs involved.

Another example of high switching costs can be found in the mobile phone industry, where customers who sign up for a mobile phone plan with a carrier receive a subsidized phone in exchange for signing a contract or agreeing to a certain length of service. Switching to a different carrier before the contract is up can result in an early termination fee, which can be several hundred dollars, and potentially having to purchase a new phone that is compatible with the new carrier’s network. This creates a high switching cost for customers and makes it less likely that they will switch to a competing carrier, even if the new carrier offers better service or pricing. Examples of carriers with high switching costs include Verizon, AT&T, and T-Mobile.

Another example of high switching costs in the automobile industry. When a consumer purchases a car, they not only pay for the vehicle itself but also for maintenance, repairs, and replacement parts. If the consumer wants to switch to a different car brand, they may need to invest in a new set of replacement parts, which can be costly.

In addition, if the consumer has built a relationship with a particular dealer or service center, they may be hesitant to switch to a new brand and have to start over with a new service provider. This creates a high switching cost for the consumer and makes it less likely that they will switch to a competing brand, even if the new brand offers similar features and functionality.

Examples of automobile brands with high switching costs include BMW, Mercedes-Benz, and Audi. These brands have established themselves as leaders in the luxury car market, and their customers are unlikely to switch to a competing brand due to the high switching costs involved.

innovation and economic moat

Jerry Neumann is discussing innovation in a context of economic moat.

and propose his taxonomy on this.

Source Jerry Neumann

Also discussion is interesting