Complete Guide to Economic Moats

It’s no secret that the ultimate goal of investing should be to maximize the odds of your success where possible.

But maximizing the odds of success requires that an investor identify valuable, long-term advantages that will help a business overcome its competitors. Sure, higher stock price, better trading volume, and increased earnings and revenue are a good sign—but they can just as easily change in a single quarter. So, what can one do amidst all that uncertainty? 🤓

The answer lies within economic moats—specific, long-term and short-term competitive advantages that are hard to replicate. These give businesses a definite edge within their industry or sector.

Moats are a dynamic fact of business—they evolve, change, and new moats are constructed. In much the same way, moats aren’t a guarantee—they can be subverted, overcome by competitors, or simply fizzle out.

So, how can an investor best identify and make use of these advantages? That’s what we’ll be covering—what exactly constitutes a moat, how to compare different companies on the basis of their moats, and the factors that can lead to such a decisive advantage.

This topic is evergreen—it’s going to be of use no matter if the goal is maximizing returns or weathering the storm of a high-inflation environment. More to the point, learning about economic moats is an important skill—it allows you to more easily identify who the industry leaders are, and who has the potential to become one in the future.

What Exactly is an Economic Moat? 📚

An economic moat is a source of sustainability and strength for a company’s competitive advantage. The term was popularized by the famed oracle of Omaha, Warren Buffet himself, who includes a perspective of moats in almost every shareholder letter for Berkshire Hathaway.

So why is the name so strange? Well, it’s because Buffet is fond of analogies. A moat is a deep ditch that used to surround cities and castles in the past. The function of a moat is to keep intruders out if possible—and if not, to slow them down.

This is the same way these important competitive advantages function. For example, if you have access to cheap materials used in the production of a product, your competitor will struggle with the fact that you can pass the discount on to consumers and price them out of the market.

In essence, an economic moat is the ability of a company to remain more profitable and retain more market share than competitors.

An Economic Moat’s Understanding 👨‍🏫

So, how do economic moats work? Well, the systemic advantages that lead to moats can come in various forms. Most of these advantages are unique to a particular company in an industry or a sector—the key to recognizing a moat is that it is hard to replicate or overcome.

For example, a company with a famous brand enjoys increased recognition and other benefits relating to marketing that competitors can’t easily replicate. In the same way, a business that has patented and protected products or processes enjoys a competitive advantage that will last for a long time and guarantees a strong share of the market in question.

Keep in mind, however, that being an industry leader doesn’t automatically mean that a company has a moat. It is the nature of competition—as soon as an advantage is detected, other companies will try to replicate it. 

One of the better examples here is Apple—although it benefits from many of the avenues which can form a moat (and which we will go over later in the guide), over time, Apple’s competitors adapted, and now the question of whether Apple even has a moat is a valid one—and if it does, it’s a not nearly as effective as it used to be.

How to Calculate Economic Moat 🧮

When it comes to calculating an economic moat, things become a tad bit trickier. There’s no one formula or equation that can let you know just how durable and profitable a company’s moat is. In essence, finding out that information about a particular moat is a matter of listening to analysts, and knowing how to identify the avenues in which a moat can occur by yourself.

Just to be clear—economic moats are objective facts, and analysts base their assessments on concrete data, such as sales, profits, cash flow, market share, and other information that can be gleaned from financial reports. We’re not knocking that approach—on the contrary, listening to analysts is key—but doing all of that work on your own is simply beyond the ken of most retail investors.

Because of the immense number-crunching that is required to do your own research, we’re going to be focusing on the tell-tale signs of an economic moat, as well as the various ways in which moats can take shape. However, we strongly suggest that you get access to the work done by analysts—so let’s first deal with the topic of moat ratings before moving on.

What Does a Moat Rating Imply? 🧐

It’s clear that the competitive advantages that lead to economic moats must be approached on a case-by-case basis—the subject matter is far too varied for there to be a set of universal criteria that can be applied in all cases. 

Depending on who is doing the analysis, different methodologies, rating scores, and criteria are applied. However, we can talk about a few general terms that always apply—these will give you an avenue to better understand and decipher various moat ratings.

In general, it is commonly held that there are two distinct types of moats—wide and narrow moats. Wide moats are superior—they offer competitive advantages that are expected to last for the next two decades, barring any major unexpected changes. Narrow moats, on the other hand, are expected to last a decade at most.

Of course, in the world of business, nothing is static. Moats are subject to change—but thankfully, most analyst reports also include an assessment of whether or not a company’s moat is improving, increasing, reducing, or holding steady.

Wide moats that are holding steady or improving suggest that the business in question might very well be a good opportunity for a long-term investment. But don’t think that narrow moats aren’t useful—for example, short-term traders such as swing traders or day traders can use the presence of a narrow moat to narrow down (pun intended) their search for good trading opportunities.

Different Types of Economic Moats Explained

Hopefully, by now you can understand the basics of economic moats—but general information won’t be enough. To properly identify a meaningful advantage and successfully exploit it, an investor has to know exactly what to look for, or in other words, what types of economic moats might be encountered.

Before we move on, keep in mind that moats are an incredibly varied subject—while a vast majority fits into the five categories we’ve covered, unique advantages do exist. Finding and making use of moats is a skill, and as such, it takes practice. In time, you’ll be able to easily ascertain whether or not a unique moat is present—but for the time being, let’s stick to the basics.

Switching Costs 💱

Switching costs refer to the drawbacks of stopping the use of a particular product or a company’s services. There are two primary ways in which switching costs operate—as traditional, financial costs, or disruptions that require time, effort, or administrative work to overcome.

In essence, this accomplishes a single goal—it makes the prospect of switching to a competitor’s product or services much less profitable. If a business is positioned in a way that allows it to make switching to an alternative unprofitable, it has effectively achieved a high level of customer retention and practically locked in a client base.

A couple of examples will help you recognize this type of moat—and it’s highly likely that you’ve encountered it before in your personal life. For example, switching mobile operators is often an arduous and unpleasant experience—during this process, you might have to cut a contract short and pay a premium, or perhaps even purchase an entirely new phone. In much the same way, switching insurance providers is also an example of switching costs in play.

Plenty of tech companies have seen tremendous growth over the past 20 years—and we’re not only talking about returns. The largest tech companies today cultivate entire ecosystems of products, which are usually quite complex—and the building blocks are interdependent. 🏗

From the perspective of an everyday person, for example, switching from Apple’s products to a competitor’s is unappealing—access to the cloud, back-ups, and the synergy of Apple’s products is reduced if you decide to choose a different type of laptop or cell phone, for example. While this could be alleviated by making the wholesale switch to another provider of the same services, that requires a significant investment, and it is quite time-consuming.

Intangible Assets 🕵️‍♂️

Intangible assets encompass factors such as brand awareness and intellectual property such as patents, government licenses, and contracts. When it comes to intangible assets, quantifying the exact width of a moat is a long shot—when looking at things from this angle, try to focus solely on identifying the presence of a moat.

Because this type of moat cannot be accurately used to judge how efficient or long-lasting a competitive advantage might be, it is preferable to always use another criterion when deciding what to invest in. 

Put another way, intangible assets on their own might not be enough to justify investing in a business—but if those assets are combined with another advantage, such as switching costs, then you might be dealing with a good opportunity on your hands.

We’ll stress it again—because this type of economic moat is hard to quantify, take extra care and pay attention to the fundamentals before deciding on a course of action. Brand recognition and patents are factors, yes—but if those factors don’t provide a quantifiable advantage with regard to metrics like EPS and ROIC, competitors will overtake the business in question in time.

Network Effect 🌐

The network effect, otherwise known as demand-side economies of scale, is the circumstance in which the benefits or utility of a good or service are increased when more people use that good or service.

Well, that is quite a mouthful—but like plenty of other things when it comes to economic moats, it’s actually quite simple once you get a look at a few examples. Let’s use the most obvious example—Facebook. Although it has fallen out of vogue lately, Facebook’s main selling point used to be that you could use it to connect and reconnect with almost anyone. Of course, that proposition only stands if Facebook can retain a large number of users.

If we’re looking for something a bit more conventional than a social network, we can use the example of an online retailer or marketplaces like Amazon or eBay. The larger the user-base, the more likely it is that you will find a product that fits your needs—and it is also more likely that someone will be selling it, due to a vast number of potential customers.

Once the user base reaches a tipping point or a critical mass, that positive feedback loop is only reinforced—like a snowball growing ever larger while rolling down a hill. Eventually, this leads to a very noticeable advantage over the competition that is hard to replicate—the very definition of an economic moat.

Cost Advantage 💵

If a business can produce goods or offer services at prices that are consistently lower than those of the competition, it has a significant advantage that can be leveraged in one of two ways. 

First, this allows the business in question to undercut competitors and price them out of the market at the cost of a temporary reduction in profit margins—in fact, some large companies have even been known to operate at a loss for years on end to get rid of competitors.

Second, it allows a company to offer its products at a slight discount or at market price—in this case, the company will experience higher profit margins, which will help drive growth and attract investor attention away from competitors.

This type of economic moat is arguably the most difficult to construct and maintain—particularly in developed economies. Because of this reason, you’re most likely only going to encounter it in large-cap companies that are already industry leaders and that control a large degree of their respective market’s share.

Efficient Scale 📊

Efficient scale refers to the phenomenon where a market is efficiently served by only a limited number of competitors. That’s not to say that there is no financial incentive to enter that particular market—investors might very well profit from entering it, but low returns of investment or high capital requirements to enter the market serve to dissuade potential competitors. After all, if investors can opt to make bigger profits with less risk, they will.

The most commonly used examples of this effect are airports. Although the U.S. does not have publicly-traded airports, plenty of other countries do. If a city already has an airport, chances are that the demand that is present is satisfied to a large degree. Sure, you could try to open up another one—but it would take a lot of money upfront, and the best thing you could hope for is a small sliver of market share.

In much the same way, utilities, certain telecommunication providers, and plenty of small or limited markets are subject to efficient scale. This, however, is a double-edged sword. While this type of moat does discourage competitors from entering the market, these markets generally don’t have a lot of room to grow.

Increased profit is what drives the market. The effect of the efficient scale is most prevalent in mature, low-growth industries.  However, this shouldn’t automatically dissuade you—these stocks might experience slow growth, but they’re much more likely to pay out appealing dividends, for example.

Economic Moat Examples 📝

Now that we’ve covered the abstract part—the theories and mechanisms by which economic moats function, let’s move on to something that’s a little more concrete and a little closer to home: real-life examples of economic moats in action.

Insurance Policy 📜

Insurance policies serve as a great example of economic moats because they benefit to a large degree from switching costs. Most people who purchase an insurance policy won’t change it—this is partly because of the ease of retaining the status quo, but it also has to do with switching costs—the administrative processes and financial costs associated with changing an insurance provider.

Because of the effect of switching costs, a lot of insurance providers are well entrenched in their areas and are unlikely to be dislodged either by competitors or new businesses that enter the market. This applies across the entire spectrum of insurance—whether we’re talking about medical insurance, car insurance, or life insurance.

Dining 🍽

When it comes to dining, the effect that is most pronounced is economy of scale. Large restaurant chains, particularly those that focus on fast food might operate on low profit margins—but they consistently maintain large percentages of market share, and the sheer scale of the business that is being conducted allows them to charge less per item.

In comparison, a family business faces a much tougher time if it wants to compete. Large restaurant chains benefit not only from the economy of scale but also from name-brand recognition, as well as cost advantages.

Brand Legacy 🛡

Companies that have been in business for a long time have had plenty of opportunities to construct a brand identity—and many have done just that with great success. It’s hard to overstate the benefits that a recognizable brand brings to the table—the issues of familiarity, quality assurance, and marketing benefits place these brands much higher up when compared to start-ups.

Although this point isn’t entirely rational, as past performance isn’t an indication of the future, people don’t always act rationally. Let’s use a hypothetical—if you were interested in investing in a luxury car marker, you’d probably go with BMW—the owners of the famed Rolls Royce, rather than a newcomer to the market that cannot vouch for their product.

Or to put it another way, with another hypothetical example—given the choice between investing in Coca-Cola or a brand new soft drink, what would you do? One of them is a beloved brand, etched into the subconscious of consumers worldwide, and a well-performing company—and the other is a big risk that ultimately faces an uphill battle for even a small percentage of the market.

Retail 🏪

Large retails are perhaps the best example of economy of scale. Because these big chains have solid and dependable supply chains, it becomes easier for them to acquire goods at better prices—then they can easily price out smaller competitors, and offer cheaper products by passing on the savings to the customer.

In comparison, small retailers cannot compete with the logistical departments of nationwide retail chains—they usually acquire goods at inferior prices, and can offer customers a narrower selection on the whole. In turn, this means that small retailers are more or less relegated to occupying a small, “niche” percentage of market share—while businesses with a size advantage, like Walmart, will continue to dominate the industry.

Narrow vs. Wide Moat Compared ⚖️

Now that we’ve covered the different types of moats that exist, as well as a few helpful examples, let’s circle back to the topic of narrow and wide moats.

As we’ve discussed, wide moats are superior—but things aren’t as black and white as they might seem. First of all, wide moats are a much rarer occurrence—on top of that, they are both more difficult to construct and maintain. If you limit yourself only to wide-moat stocks, you might be looking at precious few options.

The second most important factor is that wide moats are relatively easy to identify, once you know what you’re looking for. After all, recognizing an industry leader that has been at the top of the food chain for a while now (and has all the trappings of strong future performance) isn’t exactly quantum physics.

Don’t get us wrong—stocks with a wide moat are fantastic opportunities for long-term investing, provided that you keep track of how well the business in question can maintain its advantage. On the other hand, narrow moat stocks are a less secure proposition—but in some cases, the added risk is worth it.

Before we move on to best-case scenarios, keep in mind that narrow moat stocks with good recent performance might very well be good short-term stock trading opportunities, and sometimes even long-term opportunities.

When looking at a narrow moat stock, pay attention to the “trajectory” of the moat. Are the competitive advantages of this business something new, something which is expanding—or the fleeting remnants of a once-dominant position?

Remember—not a single business with a wide moat started out with one already in place. If you’ve found a company with a narrow (but expanding) moat—preferably before the rest of the general public, you might be looking at a future industry leader, and that’s where the possibilities for the best returns are at.

How Can You Tell If a Company Has an Economic Moat? 🤔

Although identifying an economic moat is largely a matter of recognizing certain intangible advantages, there are ways in which an investor can use cold, hard facts—metrics and statistics, in this case, to determine if a company truly does have a competitive edge that qualifies as a moat.

The important thing to note here is that you should look at all of these metrics through the lens of comparative analysis—in plain English, always compare the metrics of a company you’re analyzing with its competitors.

The first and most obvious sign of an economic moat is long-term profitability. If a company has significantly higher revenues and profits than other businesses in the same sector, it’s very likely that it will be able to retain its present market share. When assessing this angle, look at earnings, return on invested capital, cash flow, and pay special attention to free cash flow.

Another metric to consider is cash on hand—although many investors look at cash on hand as something that can be utilized to promote further growth, having a decent reserve at hands reach can also be a sign of security—a safety net in the case of a downturn or a bad quarter.

Consider the products of the company in question. A large market share is always preferable—but it isn’t always correlated with having a moat. If a company has a large market share in an industry that has a low barrier to entry, the advantage of a large market share can quickly dissipate. Likewise, industries in which patents and intellectual property law are laxer are less likely to support moats of any kind.

Economic Moat in Crypto 🪙

We’re reaching the end of this guide—by now, the benefits of economic moats, as well as their many forms should be apparent to you. So, what would go best with a business that has an economic moat? An expanding market that offers great returns—and the cryptocurrency market is an obvious example.

Let’s take a look at Bitcoin from the perspective of moats. Whether or not Bitcoin has a moat is an issue of some contention—however, we’re firmly on the side of the argument that states that it does.

Bitcoin benefits from the network effect—rising adoption leads to more transactions, stronger efforts to regulate cryptocurrency, and higher liquidity. All of which are important elements in any asset class, particularly currency.

On top of that, Bitcoin also benefits from being a first mover in the market, as well as something of a brand unto its own—any time you even mention blockchain or crypto, the first thing that comes to mind is Bitcoin.

Keep in mind, however, that these positives should also be weighed against the negatives—being an early mover isn’t a guarantee, as the cases of Yahoo and Myspace clearly demonstrate. Plus, the industry at large still has to overcome a fair number of hurdles.

As adoption increases, the utility of Bitcoin will continue to rise—even now, Bitcoin is the only cryptocurrency to be recognized as legal tender by a government. Bitcoin has seen a record-breaking increase in market cap—to over $1 trillion in under 12 years is meteoric. On top of that, the wider investing public is becoming more acquainted with it—as the large amount of interest in Bitcoin ETFs shows.

Still, while the long-term prospects of the market are good, none of this is set in stone. While Bitcoin does have a significant advantage over other crypto tokens, it will have to adapt along the way if the current moat is to be maintained.

Conclusion 🏁

This is the end of the road as far as this guide is concerned. If you’ve reached this point, congratulations on taking the time out to learn something about an important topic that isn’t discussed nearly enough.

Economic moats are an interesting topic because they delve into the practical, real-world performance of businesses and the factors that affect that performance. Knowing how to identify and leverage moats is an important soft skill—one that is essential for becoming an experienced, successful investor.

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