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.
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