What is an Economic Moat?
The word moat actually comes from the 800’s when kings would build a water moat around their castle to help protect their treasures. The same idea has transitioned into business. Businesses can now develop something Warren Buffet called an “economic moat”.
An economic moat is an unfair advantage a business would have over its competitors to stop them from taking some of their market shares and essentially, keeping a distance from their competitors. An economic moat is something a competitor can’t mimic or duplicate such as brand awareness (company logo), patents, etc. This is why well-established brands such as Facebook or Rightmove, will have a massive advantage over their competitors.
An Economic Moat Explained
Every big successful company understands that their biggest threat is truly their competition. Keeping the competition as far from reach is a priority and keeping their dominance.
In time, competitors will eat away at a companies market share if an economic moat is not developed correctly. An economic moat described a companies advantage over its competitors as a result of different business tactics that allow it to stay well above average profits for a long period of time.
Protecting the companies market share isn’t only important for the companies bottom line, but for potential investors.
Investors will always look at how wide the economic moat is between the company and its competitors. This will allow the investor to see if the company is going to last for long periods of time without losing profits. So essentially, the wider the economic moat, the greater the advantage a company has over its competitors.
Companies aren’t literally using a water moat to separate themselves from their competitors, they use intangible assets to do so. Intangible assets are something that you can’t physically touch such as brand name, pricing, etc.
These assets are what separate a competitor from one and other. Without these well-built assets, a company wouldn’t have any advantage over its competitors what so ever. Assets such as a brand are what keeps customers coming back to you, thus creating an unfair advantage (economic moat) since your competitors won’t have that same advantage.
How to widen a companies economic moat
An economic moat can be very confusing for beginners. Developing a strong economic moat is an entirely different story. Here are some of the most popular strategies for a company to widen its economic moat.
- Cash flow: The best way a company can widen its economic moat is to create large amounts of free cash flow and have a strong track record of high returns. At the end of the day, money is king. This will prove to investors that your company is profitable and has been for some time.
- Making it costly for customers to switch products: Phone contract or wifi companies make it pricey for you to switch products to convince you to stay with them as it will be the “cheaper option”.
- Pricing power: Pricing power is when a company changes its pricing due to the demand for the product. A company with a rare product might change their pricing without affecting demand as the product isn’t available elsewhere.
- Well-known trademark: This is what keeps customers buying from the same company. A well-known trademark (logo, brand) that has developed trust has a massive unfair advantage because customers will always buy from them.
- Efficient scale: The minimum efficient scale (MES) is the lowest point on a cost curve a company can produce and sell their product at a competitive price. The aim here is to keep demand high and keep pricing low.
- Network effect: The network effect is the impact whereby increased people or participants improve the value of goods or services. For example, with more people that use and post content on Twitter, the more users join. The more users join, the more advertisements are run through Twitter. The more ads run through Twitter, the more money Twitter has to grow. This goes the same for all social media platforms.
An economic moat is an unfair advantage a company has over its competitors. These advantages widen the competitive gap between companies which in return will allow a company to stay above profit for a long period of time. Without this economic moat, competitors will eat away at your market share.
Companies widen an economic moat by developing branded trademarks, free cash flow and returns, network effect, and other business strategies listed above. A wide economic moat isn’t only important to keep the companies market share and dominance but to avoid scaring off potential investors.