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Today, we’ll cover the following:

1. What is an economic moat?

2. Types of economic moats.

3. Examples of companies with wide moats.

4. Identifying economic moats.

5. Why moats matter in investing.

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In his book The Success Equation, Michael Mauboussin explained:

"The strongest businesses have a moat around them, meaning there is some form of sustainable competitive advantage that separates them from others."

Moats have been a fixture of human civilization for centuries.

A moat is a deep, wide trench filled with water traditionally built around a castle or fortress to prevent attackers from reaching the walls. The concept of a moat has always been associated with security and protection. Of course, it won't protect you from a dragon attack from House Targaryen, but it can keep most threats at bay.

But did you know that moats are also an important consideration when it comes to investing? Like a castle needs a moat to protect itself from invaders, a business needs an economic moat to protect itself from competitors.

In investing, an economic moat refers to a company's sustainable competitive advantage that allows it to maintain its market share and profitability over time.

In today's fast-paced and ever-changing business landscape, competition and disruption are becoming increasingly common in many industries. Companies that lack a sustainable competitive advantage risk losing market share and falling behind their competitors.

In this article, we'll explore the different types of economic moats and how they can turn companies into attractive investment opportunities for savvy investors.

1. What is an economic moat

An economic moat is a term popularized by Warren Buffett to describe a company's sustainable and durable advantage over its competitors, creating a barrier to entry for potential rivals. He explains:

"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage."

This advantage is typically due to one or more factors that make it difficult for competitors to replicate or surpass the company's position in the market.

Economic moats are crucial for investors because they signal a company's long-term potential for growth and profitability. And it protects the company from inevitable mistakes from management. Buffett often likes to find businesses “your idiot nephew could run:”

“We want to find a business that any idiot can run - because sooner or later, any idiot is probably going to run it."

Although a wide economic moat can provide a company with a significant edge over its competitors, it's not a guarantee of success. Disruptive technologies, changing market dynamics, and poor management decisions can all pose significant threats to a company's long-term prospects. These factors are like the unexpected dragons, earthquakes, and plagues that can wreak havoc on even the strongest fortresses.

A company has to keep reinventing itself, embracing innovation, and adapting. And sometimes, a business can run out of options when the core business is disrupted. Remember Kodak?

2. Types of economic moats

Several factors can contribute to the creation of an economic moat and make it difficult for competitors to replicate or surpass a company's position in the market.

Common types of economic moats include:

1. Intangible assets: Strong brand recognition can create a loyal customer base and allow a company to charge a premium. Patents, intellectual property rights, and government licenses can protect innovations from being copied by competitors, creating a barrier to entry for potential rivals.

2. Economies of scale: Operating at a large scale can lead to lower costs per unit and other efficiencies, making it difficult for smaller competitors to compete on price or quality.

3. Network effects: Arguably the most powerful kind of economic moat. Network effects occur when a product becomes more valuable as more users join. Social networks, messaging apps, search engines, and marketplaces are great examples. Network effects are crucial because of their compounding nature. Stay tuned for article focused on network effects!

4. Switching costs: They are the expenses, effort, and inconvenience that a customer goes through when they switch from one product to another. They can help companies retain their customer base. Examples of switching costs include data migration, retraining, and the need to purchase new equipment or software. Churn is less likely when a product is increasingly intertwined in a customer’s life, making it difficult for new entrants to gain market share.

5. Cost advantages: Producing goods or services at a lower cost than competitors can provide a competitive advantage and make it difficult for rivals to compete on price or quality. Examples include superior technology, an efficient production process, or access to cheaper raw materials.

Companies can also display soft economic moats that are more subjective and harder to quantify than structural moats. These may include intangible factors such as a company's culture or management’s reputation.

By understanding the different types of economic moats, investors can better identify companies with sustainable competitive advantages and long-term potential for growth and profitability.

These are just a few examples of the types of economic moats that a company can possess. Investors must identify the factors contributing to a company's competitive advantage and assess its sustainability over time.

3. Examples of companies with wide moats

Now that we've discussed the different types of economic moats, let's look at some real-life examples of companies with wide economic moats.

I made the selection below based on some of the best-rated companies on Morningstar's economic moat ratings over the years (more on that in a minute).

• Apple (AAPL): The company has built a reputation for high-quality products and innovative design, which has allowed it to maintain a dominant position in the smartphone, tablet, and computer markets. Apple's brand recognition and loyal customer base have helped the company maintain high-profit margins and strong revenue growth over the long term. Due to its scale, the company also benefits from lower costs per unit and other efficiencies. Apple’s ecosystem benefits from multiple network effects. Its operating system (iOS) attracts developers through its large base of affluent users. Developers make the system even more appealing with additional applications that, in turn, attract more users. New products and services enhance the value of others and make it difficult for customers to switch.

  

• Amazon (AMZN): Amazon has strong economies of scale. The company's vast logistics and distribution network offers a wide range of products at competitive prices while maintaining a profit margin. Amazon's marketplace (third-party sellers) generated cross-side network effects. Both buyers and sellers attract one another. Amazon's dominance in e-commerce has also allowed it to expand into other areas, such as cloud computing and online streaming, further solidifying its position as a leader in the tech industry. In addition, its scale enabled new revenue streams like advertising. The Prime ecosystem benefits from network effects with a growing user base funding the ever-improving value the subscription provides.

  

• The Coca-Cola Company (KO): Coca-Cola has built a strong brand and a reputation for high-quality beverages. While the company may not have a traditional network effect, its partnerships with restaurants and other beverage companies create a robust global distribution network that would be difficult for competitors to replicate. This has allowed Coca-Cola to remain dominant in the soft drink market for over a century. Additionally, the company's brand recognition and loyal customer base have helped it weather economic downturns and changes in consumer preferences. Coca-Cola has several patents and intellectual property rights, such as the formula for its signature beverage.

  

• Visa (V): Card payments are a textbook example of standard network effects. The use of one technology product encourages the use of compatible products. The company has built a global network of merchants, financial institutions, and consumers, making it the dominant player in the electronic payments industry. As more consumers and merchants use Visa's services, the value of the network increases, creating a virtuous cycle that reinforces the company's dominant position. We discuss the company in more detail here.

  

• Johnson & Johnson (JNJ): Johnson & Johnson has a strong patent portfolio. The company has a long history of innovation in the pharmaceutical and healthcare industries, resulting in a diverse portfolio of patents and intellectual property. This has allowed Johnson & Johnson to maintain a dominant position in the healthcare industry and continue to develop new products and technologies.

  

• Microsoft (MSFT): With a recognizable brand and products like Windows and Office, Microsoft has established itself as a leader in the software industry. Microsoft benefits from economies of scale due to the subscription-based nature of its business, resulting in low incremental costs for each additional user. Its operating system and productivity software create strong network effects, with each new user and business enhancing the value of the ecosystem (collaboration and knowledge base). Additionally, LinkedIn, as a social platform, also benefits from network effects, further strengthening Microsoft's competitive advantage.

  

Apple, Amazon, Coca-Cola, Visa, Johnson & Johnson, and Microsoft have all leveraged different types of moats to create a barrier to entry for potential rivals.

These are just a few examples of companies with wide economic moats. Investors must identify the factors contributing to a company's competitive advantage and assess their sustainability over time.

The durability of the moat is critical. So we want to ask if the competitive advantage can last for many years.

4. Identifying economic moats

Identifying companies with strong economic moats can be a challenge, but there are several strategies that investors can use to assess a company's competitive advantage:

• Analyze industry trends: Look for industries that have high barriers to entry or where a few dominant players have established a strong market position. For example, the tech industry has high barriers to entry due to the need for specialized expertise and significant investment in research and development. Look for categories where a competitive edge can compound over time. Understand how the market participants make money and how profit is spread.

• Assess competitive advantages: Evaluate a company's competitive advantages, such as brand recognition, economies of scale, or patent portfolio. Look for companies with a sustainable competitive advantage that will allow them to maintain their dominance in the market. Focus on:

  • Pricing power.

  • Market share gains

  • Sales & marketing expenses vis-à-vis competitors.

• Consider management quality: Evaluate the quality of a company's management team and its ability to execute on a long-term strategy. Look for companies with a track record of innovation and adaptability in the face of changing market conditions. Some questions to ask:

  • Do they share metrics openly?

  • Is management consistent in their communication?

  • Is the company celebrated for its culture and leadership on employer review sites?

• Study financial metrics: Analyze a company's financial metrics, such as revenue growth, profit margins, and return on invested capital (ROIC). Look for companies that have consistent profitability over the long term. From Buffett’s past shareholder letters, we learn several key performance indicators he loves to watch to identify a moat:

  • Gross profit margin: A high gross profit margin indicates a company's strong competitive advantage, as it can charge a premium price for its products or services. A high and improving gross margin is a sign of pricing power.

  • Return on Invested Capital (ROIC): Buffett looks for companies with a consistently high return on invested capital, which measures how much profit a company generates for every dollar invested in the business, including both equity and debt.

  ROIC (%) = [Net Operating Profit After Taxes (NOPAT) / Invested Capital]

  • A company’s ROIC should be higher than its Weighted Average Cost of Capital (WACC). This is because if a company's ROIC is below its WACC, it means that the company is not generating enough returns to cover the cost of its capital, which is unsustainable. Michael Mauboussin explained:

    “Sustainable value creation has two dimensions: the magnitude of the spread between a company’s return on invested capital and the cost of capital and how long it can maintain a positive spread.”

  • Free Cash Flow (FCF): Buffett values companies that can generate significant free cash flow, indicating that they can invest in future growth opportunities and return cash to shareholders.

  • Long-term debt-to-equity ratio: Buffett prefers companies with a low debt-to-equity ratio, which indicates that they are financially stable and not overly reliant on debt financing.

  • Earnings Per Share (EPS) Growth: Buffett looks for companies with consistently high EPS growth, which indicates that they can generate solid profits and reinvest them in the business.

Curious to learn more? We touch on many of these metrics in our comprehensive guide on how to analyze financial statements.

You can stack the deck in your favor by asking the right questions. This exercise is a way to filter for companies with higher odds of outperforming over the long term.

However, it's important to remember that no company is invincible, and economic moats can erode over time. After all, newspapers and network television stations used to have impressive economic moats. So it's crucial to continuously monitor a company's competitive position and adjust your investment strategy accordingly.

5. Why moats matter in investing

But what about the importance of moats for our portfolios?

By investing in companies with strong economic moats, investors can potentially generate strong returns over the long run:

• A virtuous business cycle: Companies with strong economic moats can maintain a dominant position in the market, resulting in consistent profitability and revenue growth. This allows these companies to reinvest in their businesses and innovate, further solidifying their competitive advantage over time or starting new initiatives—case in point: Microsoft’s investments in AI or Amazon’s success in advertising.

• Defensive investments: Investing in companies with strong economic moats also provides a level of safety and predictability. These companies are more likely to weather economic downturns and changing market conditions, providing a level of stability for investors.

• A steady income: Finally, economic moats can provide investors with a potential source of passive income. Companies with strong economic moats often pay dividends to their shareholders, providing a steady income stream over time.

Morningstar is a financial research firm that provides independent analysis and ratings of stocks and other investment securities. They use a system of moat ratings (wide, narrow, or no moat). The wider the moat, the better. The company launched the Morningstar Wide Moat Focus Index in 2002 and has outperformed the S&P 500 Index since its inception.

The key insights from their approach are:

• Companies with an economic moat will likely compound cash flow internally for many years and have a higher intrinsic value.

• High returns on capital will always diminish over time due to competition, but a few companies generate excess returns for many years.

• Structural competitive advantages can help firms recover from temporary troubles and provide a margin of safety.

• Investing in a portfolio of undervalued wide-moat stocks can earn better-than-market returns over the long term.

• Valuation is critical for wide-moat stocks, and patiently buying quality firms at attractive prices is vital to long-term investing success.

You’ll often hear Buffett suggesting, "it's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” In short, sometimes you must pay up for quality. Pat Dorsey explained:

"A company with a wide moat may be worth paying a premium price for, because it's likely to compound its intrinsic value for a longer period of time than a company without a moat."

Bottom line

Economic moats are a crucial consideration for investors when selecting companies to invest in. By identifying companies with substantial competitive advantages and potential for long-term growth, investors can potentially generate solid returns and build a diversified investment portfolio.

Investing in companies with economic moats requires patience, discipline, and a long-term perspective. While economic moats provide a level of safety and predictability, they can also take time to develop and maintain. Therefore, it's crucial to continuously monitor a company's competitive position and adapt your investment strategy accordingly.

You’ve learned:

• What an economic moat is.

• The most common types of economic moats.

• Concrete examples with well-known companies.

• How to spot them through market research and financial analysis.

• Why you should care based on their outperformance over the long term.

Spotting companies with an economic moat starts with asking the right questions.

I hope this article has inspired you to do just that.

That’s it for today!

Stay healthy and invest on!

Disclosure: I am long AAPL, AMZN, and V in the App Economy Portfolio. I share my ratings (BUY, SELL, or HOLD) with App Economy Portfolio members here.

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