As far as I know, Warren Buffett coined the expression “wide moat” to describe the large competitive advantage a company might have over its competitors.
Comparing a company to a castle and competitors to the barbarian at the gates was such a beautiful idea! The wider the moat, the harder it’s going to be to take down the castle!
The Art of War
Business is like war. A company get market shares and try to grow its presence in the market while other companies do the same.
Here comes competitive advantage. By making it hard to other companies to enter the market or to steal market shares, this insure the company should stay in business longer, which should also give you some protections for your invested capital.
But, more than security, competitive advantage usually also means that a company with a wide moat is able to earn consistently more with the same invested equity than its competitors. We call this “ROE” or “return on equity”.
If a company consistently makes a better return on equity than its peers, this means its managers should have more cash available to reinvest, grow and widen the moat!
Over the long run, wide moat companies generally make better investments, because they are safer and because they make you earn consistent growing return on your invested capital.
What gives an economic moat?
Economies of scale definitely gives a wide moat! It could be next to impossible for a competitor to catch up if they have thin margins because of their size. The bigger company could easily get rid of competition by lowering its prices for a while.
The ability to produce at lower costs than competitors can also certainly help widen the moat. Cheap labor, government incentive, better and cheaper access to resources or energy can help a company outgrow its competitors.
Patents, licences, copyrights are protections given by governments to help some businesses make a lot of money. We can see that a lot with engineering and healthcare companies.
Corporate culture like the one we can find at Google! When you are able to hire the bests of the bests and you give them the space they need to be at their best than this can give you a competitive advantage.
A well positioned brand can give a company a great advantage. With the exact same product accomplishing the same task or resolving the same problem, a well-known brand should be able to sell the item for more and make more profit!
A huge network. Think of Facebook or Ebay. The network gives them a huge competitive advantage over their competitors.
High switching cost. IBM’s business customers would have a high switching cost and even though some might not be happy all the time, before spending millions to switch provider, they’ll think about it twice!
An extensive distribution network is another characteristic that could improve a company’s economic moat. Think of Coke. Its extensive network is without common measure. Try to start a soft drink company tomorrow that could compete with Coke!?
The wider the moat, the better protection of your capital and the better potential return one could potentially make.
I try to invest mostly in wide to narrow moat stocks, but always in stocks of companies who have a serious competitive advantage and high barriers to entry!
What about you? Is a wide economic moat important for you?
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