Economic Moat

The term “economic moat,” popularized by Warren Buffett, refers to a business’s ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share. Just like a medieval castle, the moat serves to protect those inside the fortress and their riches from outsiders.

“Economic moat” is a term that refers to a business’s ability to maintain a competitive edge over its competitors. The analogy relates to the moats that would surround medieval castles and act as a barrier of protection. Ways in which a company can create an economic moat include creating advantages in size, intangibles, cost, and high switching costs. The term economic moat was made popular by legendary investor Warren Buffett.

Remember that a competitive advantage is essentially any factor that allows a company to provide a good or service that is similar to those offered by its competitors and, at the same time, outperform those competitors in profits.

A good example of a competitive advantage would be a low-cost advantage, such as cheap access to raw materials. Very successful investors such as Buffett have been adept at finding companies with solid economic moats but relatively low share prices.

One of the basic tenets of modern economics, however, is that, given time, competition will erode any competitive advantages enjoyed by a firm.

This effect occurs because once a firm establishes competitive advantages, its superior operations generate boosted profits for itself, thus providing a strong incentive for competing firms to duplicate the methods of the leading firm or find even better operating methods.

Let’s return to the example of a low-cost advantage. Suppose you have decided to make your fortune by running a lemonade stand. You realize that if you buy your lemons in bulk once a week instead of every morning, you can reduce your expenses by 30%, allowing you to undercut the prices of competing lemonade stands.

Your low prices lead to an increase in the number of customers buying lemonade from you (and not from your competitors). As a result, you see an increase in profits; however, it probably wouldn’t take very long for your competitors to notice your method and employ it themselves. Therefore, in a short period of time, your large profits would erode, and the local lemonade industry would return to normal conditions again.

Other common financial analogies include referring to the stock market as a casino, bonds being the anchor of a portfolio, and having no financial plan is like skydiving without a parachute.

However, suppose you develop and patent a juicing technology that allows you to get 30% more juice out of the average lemon.

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