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I’m sure many of you are not familiar of the term “Economic Moat.” It’s something that many value investors have borrowed from Warren Buffett. According to Buffett, the key to outsized gains in the stock market is buying companies with built-in economic moat at an attractive price.
In today’s post, we will discuss the basics of economic moat.
You may have read stories about Knights and Castles during the Medieval Times. The super villains during those period have developed different ways to capture the castle. Those wise advisers of the King suggested that they build a moat around the castle. A moat is a deep broad trench filled with water. The wider the moat, the better the castle’s defenses. And, yes – fill the moat with lots of crocs.
In a similar fashion, a company is like a castle. Its owners (a.k.a. shareholders) live on it. It constantly gets attacks from its competitors. For the castle to survive, its first line of defense is its competitive advantages.
For a company, there are various sources of moat:
- Low Cost Advantage (Think Walmart!)
- Switching Cost (If you’re a Microsoft user, you wouldn’t want to change over Linux)
- Market captivity or brand names (Why would you want to go to another street for your morning Starbucks?)
- Economies of Scale
- Licenses, Patents, Legal Rights, etc
We’ll give you an example to illustrate the point.
Take for example Coke. Its moat could be a wide as all Coca-cola bottles and cans around the world lined up on the ground. They have both market captivity and economies of scale working for them. Moreso, they have achieved something very few companies have: the ability to raise prices. Of course, any firm can raise the prices of their products. The bottomline is that whether it would cause lower volumes.
Coke doesn’t have a problem with price increases. I’m sure you wouldn’t mind paying for a higher priced Coke in a fancy restaurant even if it sells cheaply in a convenience store. This is a mega crocodile living in the moat. With its size and scale, there very little the competitors can do to penetrate Coca-Cola’s moat.
However, just some word of advice. Difference companies have different sizes of moat. Most managers usually fall into thinking that they would don’t need to do anything if the company has moat. The role of the manager is to widen the moat year in and out.
One classic example where its economic moat vanished is Kodak. Anyone who have lived and seen the technology boom would attest that Kodak is the leading brand of photography and cinematography. Their moat virtually vanished when digital camares started to hit the market. Although they do have digital products, they were late in the game. The early players of the digital age have already captured the market.
Like any good defenses, a moat should be maintained and not be allowed to dry up. If possible, it should be widened as much as possible. And yes – put in more crocs in the water!
Wondering how economic moat is useful in our research? Find out in the suceeding posts. I will also try to discuss ratios that indicate that the company may have a strong economic moat.