What is an Economic Moat?
An Economic Moat is the competitive advantage belonging to a particular company that protects its profit margins from competitors in the market and other external threats.
Table of Contents
- Economic Moat Definition in Business
- Warren Buffett on “Moat”
- Narrow vs. Wide Economic Moat
- Economic Moat Examples
- Network Effects, Switching Costs, Economies of Scale and Intangible Assets
- How to Identify an Economic Moat (Step-by-Step)
- 1. Unit Economics
- 2. Value Proposition and Differentiation
- 3. Return on Invested Capital (ROIC)
- Economic Moat Example — Apple (AAPL)
Economic Moat Definition in Business
An economic moat refers to a company with a long-term, sustainable competitive advantage, which protects its profits from competitors.
If a company is said to have an economic moat (or “moat,” for short), then it has a differentiating factor enabling the company to hold a competitive edge.
In effect, the moat leads to sustainable profits over the long run and a more defensible market share, as the advantage cannot be easily mimicked by others.
Once companies capture a sizeable percentage of a market, their priorities shift toward profit protection from outside threats such as new entrants.
The creation of an economic moat helps fend off competition – albeit all companies are vulnerable to disruption to some extent.
In the absence of an economic moat, a company is at risk of losing market share to its competitors, particularly nowadays as software continues to disrupt all industries.
Warren Buffett on “Moat”
Warren Buffett on Moats (Source: Berkshire Hathaway 2007 Shareholder Letter)
Narrow vs. Wide Economic Moat
There are two different types of economic moats:
- Narrow Economic Moat
- Wide Economic Moat
A narrow economic moat refers to a marginal competitive advantage over the rest of the market. Despite still representing an advantage, these sorts of moats tend to be short-lived.
For a wide economic moat, on the other hand, the competitive advantage is far more sustainable and difficult to “reach” in terms of market share.
Economic Moat Examples
Network Effects, Switching Costs, Economies of Scale and Intangible Assets
Common sources of economic moats include the following:
- Network Effects – Products become more valuable as the number of users acquired increases (e.g. Facebook/Meta, Google)
- Switching Costs – Positive monetary effects of moving to a different provider are outweighed by the associated costs (e.g. Apple)
- Economies of Scale – Cost of production on a per-unit basis decreases as the company expands in scale (e.g. Amazon, Walmart)
- Intangible Assets – Proprietary technology, patents, trademarks, and branding (e.g. Boeing, Nike)
How to Identify an Economic Moat (Step-by-Step)
1. Unit Economics
The economic moat will be evident in a company’s unit economics in the form of consistent operational performance and profit margins on the high end relative to the industry average.
Thus, if a company has an economic moat, sustainable long-term value creation can be attained.
If a company consistently has a better margin profile than the rest of the market, then this is typically one of the first signs of an economic moat.
2. Value Proposition and Differentiation
Just because a company has high margins does not signify a moat, because there must also be an identifiable, unique advantage.
In other words, there must be a unique value proposition and/or a strong reason behind the durability of the future profits (e.g. cost advantages, patents, proprietary technology, network effects, branding).
Additionally, the factors should be very difficult to replicate by other competitors in the market and come with barriers to entry such as high switching costs or capital requirements (i.e. capital expenditures, or “CapEx”).
3. Return on Invested Capital (ROIC)
The final KPI that we’ll discuss is the free cash flow (FCFs) of a company, which is directly tied to the company’s capacity to spend on growth and re-invest into its operations.
The more efficient a company can convert its operating cash flows into free cash flow (FCF) – i.e. FCF conversion and FCF yield – the more cash flows are available to use to obtain a higher return on invested capital (ROIC).
The creation of a long-term economic moat requires a company to find its own competitive edge, but also to recognize that its continued profit generation depends on constant adjustments to adapt to changing environments as new trends emerge (e.g. Microsoft).
As a general rule, the more defensible a company’s economic moat, the more challenging it becomes for existing competitors and new entrants to breach this barrier and steal market share.
Economic Moat Example — Apple (AAPL)
Economic moats can be viewed as protective barriers against threats to the competitive positioning of companies, so stronger moats mean higher “hurdles” for the rest of the market.
For instance, Apple is a clear example of a company with an economic moat from various sources, but the one we’ll focus on here is its switching costs.
The more difficult it is to switch to a rival offering – either due to monetary reasons or convenience – the stronger the moat is around the incumbent, or, in this case, Apple.
For Apple, not only is it expensive for customers to switch to a different product offering, but it is difficult to escape the so-called “Apple Ecosystem”.
Apple Product Line (Source: Apple Store)
If a consumer has MacBook, you can likely bet that the person also owns an iPhone and AirPods.
The more Apple products that you own, the more benefits you can derive from each product due to how compatible and well-integrated they are (i.e. “the whole is greater than the sum of the parts”).
Hence, Apple product users tend to be some of the most loyal, recurring customers.