What Is An Economic Moat?

This article originally appeared on The Div-Net on December 7, 2011

We as investors routinely refer the term “economic moat” when describing strengths of a business. What exactly is an economic moat and why does it matter? This is an important term to fully understand and incorporate into your investment research.

In a nutshell, an economic moat is a competitive advantage that a business has that prevents other businesses from infringing on its market share.

As far as I know, Warren Buffet first came up with this phrase and popularized it. He has likened a company to a castle, and the economic moat is like the moat that surrounds a castle. The wider the moat, the better defense a company has; much like a castle. Things that can provide a company a wide economic moat would be pricing power, a well-known brand name, economies of scale and large distribution networks. A company wants as wide an economic moat as possible to present a large barrier to entry into their industry. This limits competition.

I try to make sure most of my investments are with companies that have at least a narrow economic moat, and a wide one when possible. Companies that have a wide economic moat include:

The Coca-Cola Company (KO)

Coca-Cola is one of the most recognized brand names in the world, and has an extremely wide economic moat with pricing power and a distribution network most companies could only dream of. Their global reach and expanding footprint ensure that the wide moat is unlikely to cede anytime soon. Coca-cola’s pricing power can easily be seen with old time advertisements showing a bottle of Coke going for 5 cents. Try and find that today! I’m confident that Coke will be able to raise prices over time without affecting sales.

Wal-Mart Stores, Inc. (WMT)

Wal-Mart is the largest retailer in the world. It’s typically difficult for a retailer to attain an economic moat, as they rarely actually produce anything but instead sell products from other manufacturers. Wal-Mart has carved itself a wide moat through its distribution network and its ability to negotiate pricing with its suppliers and manufacturers which allow it to sell goods at a discounted rate from its peers.

Philip Morris International Inc. (PM)

Philip Morris is the international arm of Altria (MO) and owns the best selling cigarette brand in the world: Marlboro. Huge brand name exposure and a global reach ensure PM’s dominance over many decades to come. High taxes on its products lead to pricing power and this industry has large barriers to entry. PM has a global distribution network and a product that is still comparatively cheap in many parts of the world. I’m confident that the price of cigarettes will far outpace inflation, leading to increased earnings and dividends in the process. PM actually has one huge advantage on its side: its products are addictive and that only adds to its wide moat.

In the end, it’s important to focus your investment funds on companies that have economic moats. These moats provide the company a natural defense from competitors and ensure market share over time. If a company has no pricing power, doesn’t produce products that people need, has no distribution network and has no other competitive advantages then it’s probably a good idea to seek investments elsewhere.

Full Disclosure: I’m long KO, WMT, PM.

Thanks for reading.

Photo Credit:  Nick Coombs

Comments

  1. says

    I think economic moat should matter for any long term investor. I like Netflix as a user, but I don’t see how their technology cannot be replicated. Great company, but with a very narrow moat.

  2. says

    I consider a company’s moat to be the most important thing for any investment. In the end, we’re buying companies for their underlying stories and fundamentals. It’s nice to have capital gains here and there. But with a fortified moat, that company will continue to generate strong cash flow and return it to shareholders like you and me! =)

  3. says

    MoneyCone,

    Couldn’t agree more! An economic moat is definitely a priority that any long-term investor must consider before dropping hard-earned dollars on an investment.

    I concur completely on Netflix. I never liked that as an investment, and even after the shares dropped through the floor I didn’t find it attractive. Simply no moat, and what’s to stop another business from completely replicating what they have done? They are nothing more than a middle-man.

    Take care!

  4. says

    Henry,

    Absolutely! Doing quantitative analysis is all fine and great, but in the end it’s the qualitative stuff that really gets my blood pumping. What’s the story? What’s the product? Do people love it? Would I, or do I, use their product? I agree 100%!

    I love getting rewarded as a shareholder! Hopefully we continue to be rewarded for many more years to come.

    Best wishes!

  5. says

    Great article! I recently found your site through Div-Net and have been following you for a few months. Keep up the great posts.

    Also what castle is pictured? It looks like one I may need to check out on the web while saving money by not travelling to invest.

  6. says

    OK, as a user of Netflix I think they have a larger competitive advantage than they get credit for. Witness the outcry after the announcement that they were going to split the dvd business off (this move was close to that old debacle that Coke was changing its cola formula – in the end they recovered).

    This move demonstrated that Netflix customers are stickier and committed than even Netflix realized.

    However, Netflix does have an inherent problem that it and others like Pandora will face. Once their service hits critical mass (as it has recently), the content providers will want a larger share of revenue. So far, up until the most recent price increase Netflix was practically a free lunch.

  7. says

    Unknown,

    Thanks for stopping by. I’m glad you enjoy the site. I hope you stick around and keep in touch! Thanks so much for the encouragement. It’s much appreciated.

    That is Leeds Castle in England. I hear you on the traveling. Once I reach financial independence, however, that’s one of the things I’d love to do.

    Best wishes!

  8. says

    SFI,

    Thanks for adding that.

    I suppose it’s all in how you look at the company. In the end, they are simply a content provider which is a very competitive market. Speaking as someone who used to have Netflix, I find myself quite happy these days to rent the occasional movie from Redbox.

    I’m not saying Netflix can’t continue to keep customers and make money, but I wouldn’t say they have any type of “moat” to speak of. At least, that’s just my opinion. I don’t find it an attractive company from an investment standpoint as there is really nothing keeping another company from infringing on market share and doing the same thing for less money. They simply ship and stream movies.

    Just my opinions. :)

    Best wishes!

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