An economic moat is a metaphor that refers to businesses being able to maintain a competitive advantage over their competitors in order to preserve market share and profits. Any method that a company uses to maintain a what is a moat competitive edge can be considered an economic moat. Being big can sometimes, in itself, create an economic moat for a company. This is when more units of a good or service can be produced on a larger scale with lower input costs.
- Just because a company has high margins does not signify a moat, because there must also be an identifiable, unique advantage.
- From an investor’s view, it is ideal to invest in growing companies just as they begin to reap the benefits of a wide and sustainable economic moat.
- The Walls of Benin were a combination of ramparts and moats, called Iya, used as a defence of the capital Benin City in present-day Edo State of Nigeria.
- As explained, in the Coca-Cola system, as the company enters new markets, as a go-to market strategy, it will control most of the operations.
- Another type of economic moat can be created through a firm’s intangible assets, which include items such as patents, brand recognition, government licenses, and others.
- Those factors combined are all part of your business model recipe, and it often becomes evident only in hindsight.
Sources of Economic Moats
Once an Autodesk customer starts using its software, he is unlikely to switch, allowing Autodesk to charge premium prices for its products. Intangible assets refer to the patents, brands, and licenses that allow a company to protect its production process and charge premium prices. Pharmaceutical companies earn high profits due to patented drugs after spending billions on research and development. 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).
Soft Moats
So dominating the competition and keep improving the operating profit margins along with bottom line is a clear sign the company is developing a moat. If the cost of production is ₹10 and if it can sell it for ₹50, it has a very high-profit margin. The reason the company can’t sell the product at ₹50 is that competitors sell them at ₹20. Economic moats are generally difficult to pinpoint at the time they are being created.
Built between 1880 and 1881 in response to fear of a Russian invasion, it is a pentagonal fortress concealed behind grassy embankments and surrounded by a water-filled moat. The walls are built of a ditch and dike structure, the ditch dug to form an inner moat with the excavated earth used to form the exterior rampart. The Walls of Benin were a combination of ramparts and moats, called Iya, used as a defence of the capital Benin City in present-day Edo State of Nigeria. It was considered the largest man-made structure lengthwise, second only to the Great Wall of China and the largest earthwork in the world. Recent work by Patrick Darling has established it as the largest man-made structure in the world, larger than Sungbo’s Eredo, also in Nigeria.
For players in industries where the products offered are mostly undifferentiated, moats are created by economies of scale combined with low costs. Companies with sustainable cost advantages can maintain a very large market share of their industry by squeezing out any new competitors who try to move in. As you can see, a company’s economic moat represents a qualitative measurement of its ability to keep competitors at bay for an extended period of time. One of the basic tenets of modern economics, however, is that, given time, competition will erode any competitive advantages enjoyed by a firm.
A brand moat is created when a company builds a powerful brand presence around its products or services. Consumers tend to gravitate toward familiar and trusted brands, making brand loyalty a significant factor in strengthening this moat. Building a brand moat often requires years of consistent quality and customer satisfaction. For example, Coca-Cola’s global brand strength is a classic example of this type of moat. Apple has a few economic moats, the primary one being creating products that did not exist before, such as the iPod, the iPhone, and the iPad.
These examples are programmatically compiled from various online sources to illustrate current usage of the word ‘moat.’ Any opinions expressed in the examples do not represent those of Merriam-Webster or its editors. Understand what’s the killer use case that makes your product valuable in the hands of several types of customers is another key ingredient. Examples of this are companies that are opening up new markets, that are still yet to be defined (take the Uber case).
Distribution Moat
The existence of a moat was a natural result of early methods of fortification by earthworks, for the ditch produced by the removal of earth to form a rampart made a valuable part of the defense system. With the development of firearms, the moat lost much of its importance but was occasionally retained into the 18th century as an obstacle against infantry attacks. Moats were excavated around castles and other fortifications as part of the defensive system as an obstacle immediately outside the walls. A moat made access to the walls difficult for siege weapons such as siege towers and battering rams, which needed to be brought up against a wall to be effective. A water-filled moat made the practice of mining – digging tunnels under the castles in order to effect a collapse of the defences – very difficult as well.
Types of Economic MOAT for Companies
Economic moats are difficult to express quantitatively because they have no obvious dollar value, but are a vital qualitative factor in a company’s long-term success or failure and in the selection of stocks. Just because a company has high margins does not signify a moat, because there must also be an identifiable, unique advantage. Hence, the necessity for companies to build a moat, which is essentially a mechanism to deter new developments in the industry and threats that pose a material risk to their long-term viability. In short, are you willing to test, and experiment with your product to find value propositions that fit the market? In a software world where hundreds of new products are launched to market everyday, building up differentiation (in terms of features, technology, and value proposition) is a key element. One of the most powerful business defences is the brand, or the direct access to your customer base.
Excellent examples of these can be found in Newport, Rhode Island at Miramar (mansion) and The Elms, as well as at Carolands, outside of San Francisco, California, and at Union Station in Toronto, Ontario, Canada. Additionally, a dry moat can allow light and fresh air to reach basement workspaces, as for example at the James Farley Post Office in New York City. A moat is a deep, broad ditch dug around a castle, fortification, building, or town, historically to provide it with a preliminary line of defence. In some places, moats evolved into more extensive water defences, including natural or artificial lakes, dams and sluices. In older fortifications, such as hillforts, they are usually referred to simply as ditches, although the function is similar.
If, by luck, good timing, or continued growth, the company is able to sustain this mode of aggressive growth, a competitive advantage can be created. While strong products and brands can draw directly from their user or customer base. Companies with significant cost advantages can undercut the prices of any competitor that attempts to move into their industry, either forcing the competitor to leave the industry or at least impeding its growth. As a result, you see an increase in profits; however, it probably wouldn’t take very long for your competitors to notice your method and employ it themselves. Therefore, in a short period of time, your large profits would erode, and the local lemonade industry would return to normal conditions again. Dry moats were a key element used in French Classicism and Beaux-Arts architecture dwellings, both as decorative designs and to provide discreet access for service.
Other common financial analogies include referring to the stock market as a casino, bonds being the anchor of a portfolio, and having no financial plan is like skydiving without a parachute. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance.
Efficient scale arises when a particular market is best served by a limited number of companies, giving them near-monopoly statuses. Utility firms are examples of companies with an efficient scale that is necessary to serve electricity and water to their customers in a single geographic area. Building a second utility company in the same area would be too costly and inefficient. For instance, Apple (AAPL) 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. 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.
