Competitive Advantage and Moats

In a competitive market, high profits attract rivals, and rivals push profits down. Companies that keep earning high returns for decades usually have something that stops competitors from copying them. Warren Buffett popularised the term "economic moat" for this kind of durable competitive advantage, comparing a great business to a castle protected by a wide moat. Identifying moats helps investors judge whether today's profits are likely to last, which is central to valuation.

Sources of moats#

The research firm Morningstar uses a similar framework to rate companies' moats.

Moats in the numbers#

A moat should show up in financial results over long periods:

How moats erode#

• Technology change: digital cameras eroded film; streaming eroded video rental.
• Regulation: patent expiries, antitrust actions or deregulation.
• New business models: online retail disrupted department stores.
• Management mistakes: neglecting the product or overpricing.
• Changing consumer tastes.

Moats are rarely permanent, so investors watch for signs of narrowing, such as falling margins, losing share or rising customer churn.

Moats and valuation#

A durable moat lets a company reinvest at high returns for longer, which justifies a higher valuation multiple. But moats are widely recognised, so great companies often trade at high prices. Paying too much for a wonderful business can still produce poor returns. See Valuation Basics and DCF Valuation.

Moats and the quality factor#

Companies with high profitability, stable earnings and strong balance sheets tend to have moats. Academic research on the quality factor has found that such companies have historically delivered better risk adjusted returns than low quality companies. See Quality and Profitability Factors.

Questions to ask#

1. Why can't a well funded competitor copy this business?
2. What would customers lose by switching?
3. Has the company raised prices without losing customers?
4. Are returns on capital high and stable over a full cycle?
5. What could make the advantage disappear?

Frequently asked questions#

What is an economic moat?#

A durable competitive advantage that protects a company's profits and returns from competitors over long periods.

What are the main sources of moats?#

Network effects, switching costs, intangible assets such as brands and patents, cost advantages and efficient scale.

How can I tell if a company has a moat?#

Look for returns on capital consistently above the cost of capital, stable high margins, pricing power and loyal customers over many years.

Next, learn to analyse profit per customer in Unit Economics.