“In business, I look for economic castles protected by
unbreachable ‘moats’.” - Warren Buffett
unbreachable ‘moats’.” - Warren Buffett
The term "economic moat" was coined by Warren Buffett to describe companies which possess what he calls a "durable competitive advantage". An economic moat is essentially a structural characteristic that enables a company to earn high returns on capital for prolonged periods of time without relinquishing market share to competitors. These moats can take various different forms and some are wider and deeper than others.
- Network Effect : A network effect occurs when the value of a product or service increases as more people begin to use it. As the number of points within the network grows the number of possible connections increases exponentially. Examples of companies which possess a network effect are American Express (AXP), Visa (V), Master Card (MA), Ebay (EBAY), Facebook (FB).
- High Switching Costs : It can often be costly, both in terms of time and money, to switch from one product or service to another and as such customers tend to become attached to a particular company's services. These costs may be fees and charges incurred in order to switch to another provider or they may be the cost of time and effort required to transfer to another service. Examples of companies with high switching costs are Automatic Data Processing (ADP), Paychex (PAYX), Oracle (ORCL), Autodesk (ADSK), Intuit (INTU), Fiserv (FISV)
- Intangible Assets : Intangible assets may take a variety of forms including unique corporate structure, brand names, copyrights, trademarks, patents, licences and other Government approvals. Warren Buffett's favorite companies are those which possess an economic moat stemming from intangible assets, particularly brands, as these are the hardest to be challenged or replicated by competitors and as such they possess the"unbreachable moats" that Buffett speaks of. Examples of companies which possess a moat stemming from intangibles include Coca-Cola (KO), Colgate Palmolive Co (CL), Reckitt Benckiser Group PLC (RB.), Core Laboratories (CLB). Special note should be made of companies which own what Buffett calls a "share of mind". These are companies whose brands are so powerful that they occupy part of the consumer's mind granting them pricing power. Buffett discussed this concept in relation to See's Candies at a Q&A session with business school students at the University of Florida. “There was something special. Every person in California has something in mind about See’s Candies and overwhelmingly it was favorable. They had taken a box on Valentine’s Day to some girl and she had kissed him… See’s Candies means getting kissed. If we can get that in the minds of people, we can raise prices.” This is the reason why Buffett has taken fractional or full ownership in Coca-Cola, Duracell, Wrigleys, Heinz, Gillette etc. When you think of a given commodified product such as chewing gum, razors or batteries you instantly think of these companies, ergo they own a share of your mind.
- Cost Advantages : Cost advantages allow a company to charge the same price as it's competitors and earn excess profits or to undercut them and increase it's market share. Cost advantages may arise from economies of scale which facilitate increased outputs at lower costs. Increased scale in the size of operations can lead to increased bargaining/purchasing power with suppliers. Lowest cost production/operation & Low-cost resource base is another cost advantage which can result in excess profits or increasing market share. Examples of companies which possess cost advantages are Walmart (WMT), United Parcel Service (UPS), Intel (INTC), Sysco (SYY), Ultra Petroleum (UPL)
- Efficiencies of Scale : If a particular market is limited in size there is little to no incentive for new competitors to enter it. Thus an established company can earn profits in the market but new entrants would result in the returns on capital for all those involved falling below the cost of capital. A market may be limited due to niche demand or due to geographical constrains. Examples of Geographical monopolies are Quarries/Gravel pits, Race Tracks, Pipelines, Railways, Toll Roads & Bridges and Airports. Niche markets may be Defense Contractors, Aerospace and Medical Equipment etc. Examples of companies operating in niche markets include Graco Inc (GGG), Compass Group PLC (CPG), Sun Hydraulics Corp (SNHY),