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  • Writer's pictureLucian@going2paris.net

Today’s Term — Wide Economic Moat


Twilight Park

April 6, 2022


I was watching some W. Buffett YouTube videos and he was saying a term I hadn’t used before — an economic moat. I Googled it and here’s what I found:


A wide economic moat is a type of sustainable competitive advantage possessed by a business that makes it difficult for rivals to wear down its market share. The term economic moat was made popular by the investor Warren Buffett and is derived from the water-filled moats that surrounded medieval castles. The wider the moat, the more difficult it would be for an invader to reach the castle.


A wide economic moat can be caused by several factors that might make it difficult for other businesses to steal market share. These factors may include high barriers to industry entry, or the business with the moat might own patents on several products that are essential to providing their particular product or service.


KEY TAKEAWAYS

  • An economic moat is a distinct advantage a company has over its competitors that allows it to protect its market share and profitability.

  • A wide economic moat is one that is difficult to mimic or duplicate (e.g., brand identity, patents) and thus creates an effective barrier against competition from other firms.

  • Companies with a wide economic moat have are able to generate large amounts of free cash flow and have a track record of strong returns.


Understanding a Wide Economic Moat

The term economic moat, popularized by Warren Buffett, refers to a business' ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms. Just like a medieval castle, the moat serves to protect those inside the fortress and their riches from outsiders.


Businesses that possess at least one factor of Porter's 5 forces model would possess a wide economic moat. For example, a business that holds an exclusive patent for the creation of a miracle drug would effectively keep potential competitors out of its business. Having few or no competitors would allow the company to continually generate high levels of profit.


A company that exists in a business where the start-up costs are prohibitive for small entrants would also have a wide moat. There are several ways in which a company creates an economic moat that allows it to have a significant advantage over its competitors.


Sources of Economic Moats


A company that is able to maintain low operating expenses in relation to its sales compared to its peers has cost advantages, and it can undercut its competition by lowering prices and keeping rivals at bay. Consider Wal-Mart Stores Inc., which has an immense volume of sales and negotiates low prices with its suppliers, resulting in low-cost products in its stores that are hard to replicate by its competitors.


Intangible assets refer to the patents, brands, and licenses that allow a company to protect its production process and charge premium prices. While brands are typically derived from superior product offerings and marketing, patents are obtained as a result of companies' filings with governments to protect know-how for a specific period of time, typically 20 years. Pharmaceutical companies earn high profits due to patented drugs after spending billions on research and development.


Efficient scale arises when a particular market is best served by a limited number of companies, giving them near-monopoly statuses. Utility firms are examples of companies with an efficient scale that is necessary to serve electricity and water to their customers in a single geographic area. Building a second utility company in the same area would be too costly and inefficient.


Switching costs are another type of economic moat, which makes it very time-consuming and expensive for consumers to switch products or brands. Autodesk Inc. offers various software solutions for engineers and designers that are very difficult to learn. Once an Autodesk customer starts using its software, he is unlikely to switch, allowing Autodesk to charge premium prices for its products.


The network effect can further fortify a company's economic moat by making its products more valuable the more people use them. An example of a network effect is online marketplaces such as Amazon and eBay, which are widely popular among consumers because of the large number of people buying and selling various products through their platforms.


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Here’s an article from ”Inc.” on the concept and Buffett’s use of it:


When you ask most CEOs about their vision for their business, they usually give you an answer built around metrics like number of customers, market share, or profitability.

But what I would argue is that while all of those numbers are critical to the success of any business, they are really just outcomes that result from having a strong "machine" and a "moat" for your business. Let me explain what I mean by these terms. Your machine is the way your business operates in a repeatable and predictable way. A great business, for example, might know that if it gets 500 appointments, it can predict with great reliability that it will eventually land 300 customers, each of who represents a certain amount of revenue and profit. As the CEO of such a company, your job becomes pulling the different levers on that machine based on how much you might want to grow the business, knowing that you also have to account for some degree of diminishing returns. The best business machines also build in plenty of recurring revenue into their business model, such as when you have a subscribed based of customers paying you every month or renewing their contract with you on an annual basis. Companies that have a large percentage of annual revenue are extremely valuable, and attractive to private equity companies, precisely because they operate like a machine where you know going into any new year what you revenues and profits are likely to be - at last as a minimum. Your job then becomes how much more you want to hit the gas pedal. In some cases, your goal as a CEO may be to build a better machine. I work with a company, for instance, that is incredibly good at acquiring customers. But their business model is built on a transaction basis, so they are constantly working to acquire new customers. Granted, they are really good at that job. But if they could find a way to build elements of recurring revenue into their machine, where they found a way to keep many of their existing customers, they could increase the value of their business by a very high multiple. That leads us to the other element in your business you should be paying attention to: the moats that protect your business from your competitors' attacks. Great machines inspire imitation and you have to protect yourself. As I explain in my book, Great CEOs Are Lazy, if you build a profitable machine in your business, your competitors will eventually try to copy that model and steal your customers away. A business moat, therefore, is something that helps keep your customers away from your competitors. This idea was popularized by Warren Buffett. In Berkshire Hathaway's 2000 annual meeting, Buffett commented:

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. A great example of this involves switching costs, like what we have seen the cellphone industry take advantage of. By making customers pay a fee to switch or cancel a contract, these companies put up barriers for their customers to leave. That cost also makes it harder for your competitors to undercut you. Another example is an information moat. This is a situation where you have so much customer data in your system that your customers will find it too painful to ever switch from your service even if a competitor is offering a lower price. Consider a company like Constant Contact, which manages a company's entire customer database and email newsletters for them. Because someone would have to port all that data and content, it becomes particularly daunting for customers to ever consider switching. So when it comes to thinking about a long-term vision for your business, don't get caught looking at the trees when you should be looking at the forest. If you make the most of your time building your machine and your moats, the rest of the outcomes you want will take care of themselves.

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