Competitive Edge: Economic Moats Explained

Moats are designed to defend castles, palaces and towns against intruders. The same holds true for businesses. Long-term investors want companies that have a deep, well-built moat to protect the company over time since a protected company has room to thrive.

A ring of deep water is pretty easy to spot, but other moats are tougher to identify. The first step is to get a handle on the concept and then keep track of the types of moats that successful, growing companies build.

Making imitation impossible

The term economic moat was coined and popularized by the Oracle of Omaha himself, Warren Buffett. He sees the castle as the company and the moat as the durable competitive advantage that allows it to persist and grow over time. If a company's success is based on something that others can't replicate, it is much more likely to retain its top spot.

An economic moat can come in a variety of forms, such as:

• Brand power. Think luxury brands with social clout.
• Patents or intellectual property. Think pharmaceuticals or technology.
• A critical mass of users. Think social media, internet retailing or credit cards.
• Cost advantage. Think mass-market retail.
• Licenses for regulated activities. Think casinos.
• A nuisance to switch. Think telecommunications or enterprise software.

Morningstar Research Inc. describes an economic moat as how likely a company is to keep competitors at bay for an extended period. Morningstar analysts give every company an economic moat rating: wide, narrow or none. A wide rating is given when a company's competitive advantages are expected to last more than 20 years, narrow for 10 years and none for those with no perceived competitive advantage.

Strength under pressure

Because a siege could come at any time, a moat must be sustainable over the long haul. By their very nature, trends are fleeting and won't help with moat building. The competitive advantage must be a structural part of how the company functions.

Let's compare two hypothetical consumer businesses to illustrate which will better fend off an attack.

Company A sells a new and innovative fitness-class fad. Growth is explosive, classes popping up everywhere, DVDs on the market and an app in the works. Company B manufactures a patented, proprietary formula for a muscle-building drink. Growth is unremarkable but steady while the company pushes into different markets as regulations allow.

Both companies are capitalizing on a larger social shift toward healthy living, but one is vulnerable to copycat competitors while the other is protected by the power of a patent, a trademark and a deep understanding of local health regulations.

The more, the better

Moats are not permanent. The water dries up, regulations change, patents expire and cost structures can shift. Investors would be wise to look to the ancient architects of Japan when examining companies. Multiple moats were often layered in circles around Japanese castles as added protection.

The more economic moats there are around a company, the stronger it can be when competitors storm the castle gates.