Economic moat is the most important concept in investment valuation. The concept has been widely popularized by Warren Buffett since 1986 in annual letters to Berkshire Hathaway shareholders.

Economic Moat Defined

Economic moat refers to a durable competitive advantage that allows a company to generate excess returns over a long period of time. If you remember from Economics 101, markets tend to be very competitive. The equilibrium price in a perfectly competitive market is such that firms earn no excess returns.

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What do I mean by excess returns?

Excess Returns

In a valuation, excess returns arise when a company’s return on invested capital (ROIC) is above its cost of capital. The formula for the ROIC as:

\text{ROIC} = \dfrac{\text{NOPLAT}}{\text{Invested Capital}}

where NOPLAT is net operating profits/losses after taxes. As for the cost of capital, it measures the combined cost of equity and debt of a company.

To understand excess returns, imagine a simple situation. You borrowed 100 bucks from a bank, charging you a 5% interest rate. Think of $100 as your invested capital, while 5% as your cost of capital. You are thinking of investing this money into corporate bonds. If corporate bonds earn you 8%, you will earn 3% in excess returns. Anything below 5% is unprofitable.

Sources of Economic Moat

Many companies fail to generate excess returns due to competition. But, a minority succeeds by building an economic moat. So, what are the main sources of economic moat? These are:

1. Intangible Assets
2. Switching Costs
3. Network Effect
4. Cost Advantages
5. Efficient Scale

1. Intangible Assets

Intangible assets refer to patents, licenses and brands. For instance, Nvidia holds many patents related to its graphics processing units, which makes it difficult for competitors to replicate Nvidia technology. As a result, Nvidia charges premium prices for its products for gaming and cloud servers.

Intangible assets refer to patents, licenses and brands. For instance, Nvidia holds many patents related to its graphics processing units, which makes it difficult for competitors to replicate Nvidia technology. As a result, Nvidia charges premium prices for its products for gaming and cloud servers.

Another example is the brand. For instance, Apple built a strong brand around its products. When you think of an iPhone, quality, ease of use, reliability and great warranty service come to mind. Because of this, Apple can charge premium prices for its products.

2. Switching Costs

Switching costs are the costs a company’s users would have to incur to switch to a competitor’s product. Switching costs include financial cost and time to learn a new product. Also, companies will have to go through a transition phase which can disrupt its business.

For instance, there are negligible or no switching costs to buying grocery. For this reason, grocery companies cannot charge premium prices. Thus, grocery stores build economic moat through other means, such as cost efficiencies.

Consider another extreme example of the ASML company. ASML produces huge lithography machines for semiconductor manufacturing. Intel, TSMC, Samsung and others buy these machines to produce CPUs, GPUs and other chips. For super miniscule chips at 2 or 3 nanometers, there are no alternatives to ASML. Thus, the switching costs are infinite.

3. Network Effect

The network effect is common among social media and payment service providers. As more users join the network, its value grows. At some point, the network gets so large that everybody wants to be part of it. As this happens, the cost of gaining an additional user becomes negligible. Because of the network effect, the company is able to charge premium prices for its products.

For example, take Facebook. As its network grew to gargantuan sizes, advertisers flocked to Facebook. The reach to a diverse group of consumers on Facebook remains one of the best out there.

Conversely, there are dozens of social networks you never heard of. All of them failed due to an inability to gain size. Google Plus is one of them that comes to mind.

4. Cost Advantages

Another source of economic moat is cost advantage. One example of cost advantages is the economies of scale. The economies of scale allow companies spread their fixed costs over a large number of products. This lowers the company’s cost per unit.

For instance, consider Costco. Costco built a large network of warehouse stores that sell goods in large quantities. Due to this, suppliers are willing to negotiate lower prices with Costco to tap their scale of sales.

Companies can achieve cost advantages through other means, such as innovative business processes. A prime example of this is Ikea.

Ikea became the largest furniture company in the world for a reason. They design their products in a standardized manner suitable for self-assembly. This allowed Ikea to drive production and storage costs to a minimum.

Another example of efficient business methods is Amazon’s highly automated distribution centers. Due to this, Amazon can reduce reliance on costly labor, speed up delivery times and minimize errors.

5. Efficient Scale

Finally, there is an efficient scale which can produce economic moat. You often see this among regulated or capital-intensive businesses in certain geographies. For instance, a small city does not need two airports or two utility companies. Having too many utilities or airports is inefficient and unprofitable. For this reason, these businesses serve as monopolies in certain geographic areas. In return, these companies are often subject to regulation.

How Do Companies Sustain Economic Moat?

In particular, pay attention to the following things that can help companies sustain economic moat way into the future.

1. Length of Product Life Cycle

First, watch how competitive advantages play into the length of product life cycle. The longer the life cycle, the more durable competitive advantage is.

For instance, Amazon AWS cloud products have a high degree of switching costs. It takes time to learn the new platform. Moreover, the transition to a new cloud provider can be costly and disruptive to the business. For this reason, once users park their business with Amazon AWS, they are unlikely to switch. This shows that Amazon AWS enjoys a long product life cycle and can earn excess returns for years to come.

On the hand, fad products that earn excess profits short-term are like one-trick ponies. Once consumers get tired of them, the excess profits evaporate. Here is a prime example: Instant pots produced by Instant brands.

Instant pot was a hit, especially shortly before and during the pandemic. The problem was that households do not need 2 or 3 instant pots. Moreover, many copycats emerged. Once consumers stocked up on pressure cookers, instant pot sales tanked. In fact, sales were so bad, that the company had to declare bankruptcy in 2023.

2. Persistence of Competitive Advantage

Second, see if a competitive advantage can persist into the future. If not, excess returns you observe are likely temporary. For instance, early adopters of automation in the auto industry enjoyed lower manufacturing costs. But, as all major players caught up to factory automation, it was no longer an advantage. Later, auto makers began passing down cost savings to consumers through price reductions.

3. Product Renewals

Finally, watch for a company’s ability to renew its products to stay competitive. If a firm dozes off, competition is just around the corner.

For instance, everyone knows about Blockbuster. The company heavily relied on its physical stores to rent movies. But, Netflix came around and started shipping DVDs instead. This allowed Netflix to keep its cost structure light. At the end, the slow-moving Blockbuster failed to adapt and went bankrupt. Moreover, Netflix reinvented itself several times. First, it was through internet streaming and then production of its own content.

Quantitative Analysis of Economic Moat

When it comes to assessing economic moat quantitatively, there is one metric. And it is the ROIC. Companies with strong economic moat have excess returns that persist over time.

Let’s take the example of Amazon. Amazon pursued insane growth rates at the expense of profitability for a long time.

If we look at profit margins and returns ten years back, they were negligible. At the same time, Amazon clocked top line growth rate of 30% at times. But, after building strong competitive advantages, Amazon realized its return potential. We see that its ROIC increased substantially over time.

Also, observe how stable ROIC is. If ROIC fluctuates or shows declining trend, this could be a red flag worth looking into. The question becomes whether this negative trend is a temporary setback or a permanent failure.

Concluding Takeaways

So, those were the five sources behind economic moat and strategies that companies employ to sustain their competitive advantage. When you analyze a company the next time, look out for these factors to assess economic moat. While economic moat analysis is more of a qualitative exercise than a quantitative, it is the most valuable one in investment valuation.