What Are the Origins of An Economic Moat?
In the Middle Ages, castles were symbols of royal wealth; admired by all, and targeted by some. A castle's security from invaders hinged greatly upon its defensive capabilities. An especially daunting element of defense was the water channel surrounding the perimeter of the castle, commonly known as the castle's "moat." In modern day economics, the fate of publicly traded corporations is much the same as that of the medieval castle. A company's ability to protect wealth and sustain profitability in the face of attack from rivals is an essential element of survival.
In the field of finance, Warren Buffett is widely hailed as royalty. Known as the "Oracle of Omaha," he has spent a lifetime crafting and implementing various capital investment strategies. From his first purchase of stock at age 11 to becoming the driving force behind mega-corporation Berkshire Hathaway, Buffett has made a habit of turning a profit. His massive fortune can be attributed to his talent for capital allocation, risk management, and stock picking. As of August 2015, his wealth, both personal assets and share of Berkshire Hathaway, were estimated at US$67 billion.
Buffett has stood the test of time and is recognised as one of the greatest investors in history. A champion of the "buy and hold" investment strategy, and identifying companies with "intrinsic value," Buffett is credited with the creation of many investment concepts. One such concept is that of the "economic moat."
What Is An Economic Moat?
An "economic moat" is a competitive advantage that is unique to an individual company and difficult for rivals to imitate. An economic moat acts as a barrier-to-entry for competing firms aspiring to capture market share, and it protects the long-term viability of a company.
Types Of Economic Moats
The development of a competitive advantage is the basis for a company's ability to deliver sustained profitability to the shareholders. Competitive advantages come in many forms ranging from a company's cost advantage over its peers, to its intangible assets.
Economic moats vary in effectiveness depending on the strength and number of a company's competitive advantages. A company with a formidable competitive advantage has a "wide" economic moat, while a company with a vulnerable competitive advantage is said to have a "narrow" moat.
Economic Moat: Cost Advantage
A company that can produce a quality good or service and deliver it to the consumer cheaper than its competitors has a cost advantage. Cost advantages are typically industry-specific and can be attributed to lower cost inputs, process efficiency, superior technology or location. A cost advantage is often the first type of competitive advantage sought by a company entering the marketplace.
Cost-based competitive advantages enable a company to undercut competitors and dominate market share within an industry. Large retail establishments such as Wal-Mart, Costco, Lowes and Home Depot are prime examples of companies that can deliver lower costs to the consumer than their competitors.
Economic Moat: Intangible Assets And Brand Loyalty
The assets possessed by a company that one cannot readily see or touch are called intangible assets, with examples being company-owned patents, trademarks and brand loyalty.
The ability of a rival firm to compete in a specific industry can be severely hampered by a company who owns a trademark or has patented technology unique to that industry. Biotech and software companies depend on patents regarding medicine and information systems technology to create their economic moats. Media companies will copyright intellectual property and works of art in an effort to protect exclusive content from competitors and establish an economic moat based upon product differentiation.
In certain cases, brand loyalty can be the most valuable asset to a company and provide a formidable economic moat. An illustration of brand loyalty is Coca-Cola, which has been one of Warren Buffett's largest investments over the years—Berkshire Hathaway owns 400 million shares and more than 9% of the company. The brand loyalty enjoyed by the 100-year-old Coca-Cola company was one of the primary reasons for the investment. It's also a key element ensuring the soft drink giant's future prosperity.
Investing In Economic Moats
As a general rule, the more substantial the moat, the more stable the company. In reference to the types of companies in which he likes to invest, Buffett puts it simply: "I look for economic castles protected by unbreachable 'moats.'" Given his investment track record spanning the past half-century, Buffett's concept of an "economic moat" has gained widespread acceptance and popularity within the financial community.
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Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…