In these tumultuous times, securing your investments in solid companies is more important than ever. An economic moat is a good indicator of longevity, and knowing how to identify one can help you make those tough investment decisions.
In this article:
- What is a moat?
- Why do moats matter?
- What should you look for?
What is a moat?
The term ‘economic moat’ was popularised by value investment legend Warren Buffet and can be simply translated as a company’s competitive advantage.
While tracking sectors and supply and demand intricacies can be a rewarding experience as an investor, Buffet championed the Benjamin Graham school of thought, which assesses company value as a whole, rather than relying on market trends.
The base idea is to find companies with unjustifiably low share prices compared to their intrinsic worth and buy and hold those companies until the market realises their value.
Easier said than done.
Identifying economic moats are one of the ways you can pick out companies with a big enough competitive advantage to go the distance; a moat is something no one else has – or does as well.
There are five main categories of economic moats:
Brand Moat: A reputation for excellence that will survive the test of time. Harley-Davidson (NYSE:HOG) has been an icon of lifestyle branding for example, while Apple cornered the ‘interconnectivity and innovation’ branding for a good while, and still enjoys widespread brand recognition and support.
Secrets Moat: This company knows something few else do. They may have patents like Pfizer or specialised equipment and techniques like Dow Chemicals, but either way they have leverageable information or abilities that others can’t meet.
Toll bridge Moat: Often coming hand in hand with monopolisation, a toll bridge moat essentially means that if anyone else wants to enter the market, they must pay the company’s toll. Telstra is a good example of this in Australia, as it owns a huge chunk of telecommunications infrastructure and sells the use of it to other internet and phone providers.
Switching Moat: A little less self-explanatory, a switching moat is essentially an established paradigm that makes it difficult for companies to change the way they do business. Microsoft has a very wide switching moat for example, as they provide everything from operating systems to email browsers and losing access to that software would be a difficult transition for any company.
Price Moat: This company can offer products and services at a price no one else can. Whether it be through savvy supply deals or bulk manufacturing, companies like Aldi or Costco (NASDAQ:NA:COST) enjoy a price moat because their competitors cannot realistically match the savings they offer.
Why do moats matter?
While investing moats are not necessary enduring, they do indicate the longevity of value.
One of the basic tenets of modern economics is that, given time, competition will (in theory) erode any competitive advantages held by a single company. Innovation becomes best practice, which becomes commonplace.
A company’s economic moat represents its ability to maintain a competitive advantage over other similar businesses for an extended period of time.
Difficult to express in qualitative terms and holding no obvious dollar value, moats are nonetheless a vital factor in determining which companies will enjoy long-term success and which will lose their advantage over time and fail.
Many companies aren’t limited to a single economic moat, but it’s important to keep in mind that moats are not eternal – they can be lost or gained depending on supply chain logistics, market factors, or socio-political context.
Be warned that an economic moat is not the only feature you should look for; like any good medieval castle, a solid moat requires an effective leader that can maintain, capitalise on, and expand a company’s competitive advantage.
What should you look for?
While many moats are universal, often the qualities you’re looking for are sector or industry-specific.
Some universal indicators of economic moats to keep an eye on include:
- Higher than average earnings performance during economic downturns
- A solid level of cash on hand
- Higher revenue and profits compared to direct competitors
- Dominance of a single product (think Apple)
- Powerful intellectual property
- Name recognition
From here, deciding what constitutes a moat will require some industry-specific knowledge.
In the mining sector, you might look for processing or extraction technology patents, exceptional access to energy and freight infrastructure, vertically integrated processing, or a globally significant deposit of ore.
The biopharmaceutical sector is very patent-dependent, but a savvy investor might also look for research partnerships with top universities that provide robust development pipelines, far-reaching distribution agreements or expert-promoted treatments that address unmet needs.
The technology industry is also dominated by patents, but the infrastructure is also very important. Look for tech companies that service other tech companies or provide infrastructure for different industries altogether, as it’s much harder to usurp foundational technology than the new shiny gadget on the market.
Investment moats are not infallible, but they are good indications of continued value and potential growth. Think about what sets companies apart, and why they often eventually lose that top spot.
As with anything related to your wallet, do your research thoroughly and understand what you’re buying and why you’re buying it before you make that final purchase, lest you end up in the moat yourself.