To be completely honest from the start, it's not Buffett's original theory. While its roots are difficult to trace, he popularized the concept in the 1980s and used this term in his letters to Berkshire Hathaway shareholders.
One of Buffett's favorite metaphors, "economic moats" — like those used to protect medieval castles — refers to the features that defend the company from competitors. These moats reduce the impact of competitive rivalry, thereby protecting the company, its shareholders, retail investors, and employees.
Every successful company's long-term sustainability lies in its ability to guard itself with effective "moats" to maintain its position among the market movers.
There's no definitive list of economic moat components. We'll break them down into tangible and intangible.
Intangible components of an economic moat
- Brand: After a company has established itself and gained wide recognition, it enjoys a significant advantage — consumers prefer original, well-known brands over generic or lesser-known alternatives. For example, approximately 95% of people worldwide recognize McDonald's, and around 73% of them live in countries where the brand operates.
- Customer trust: A well-known brand inspires instinctive trust, encouraging customers to return. Trust is crucial — it can be a tough challenge to regain once lost.
- Patents and trademarks: These legal protections guard against unauthorized use of a company’s in-house developed products. They work not only as a shield from competitors but also signal commitment and quality to customers.
- Regulatory licenses: Government-issued licenses are essential for operating in specific economic activities, such as oil, tobacco, or liquor production.
- Customer loyalty: Built through exceptional service and product quality. It affects brand recognition and trust. In times of economic downturn, a loyal customer base can sustain a company.
Tangible components of an economic moat
- Cost advantages: Achieved through lower logistic costs, cheaper manufacturing, and other ways of reducing input costs. This enables a company to offer products at more competitive prices relative to industry rivals.
- Efficient scale: This refers to existing companies operating within this industry that serve the available market efficiently, making it uneconomical for new entrants. For example, there are usually just a few utility companies in a city, a limited number of gas pipelines, or dominant retailers like Walmart, which operate at optimal scale within particular regions.
- Distribution networks: Сompany's robust logistics, which is costly to replicate, becomes an economic moat component, enabling fast, cost-effective delivery while minimizing supply disruptions.
- Real estate and location advantages: A company's physical presence in prime locations can be a critical moat. McDonald's is a great example — it carefully selects high-traffic areas for its Drive-Thrus while owning the underlying land leased to franchisees.
- Capital intensity: Some industries require a high initial investment for businesses to enter. These are utility companies, railroads and airlines, the semiconductor industry, and pharmaceuticals. These high capital and regulatory barriers serve as powerful deterrents to competitors.
Worth noting that having a moat does not guarantee immunity against rivals. To be truly effective, moats must meet certain criteria:
- Durability: The moat should have a proven track record of protecting the company over many years or decades.
- Difficult to replicate: Unique partnerships, well-thought-out distribution routes, patents, and massive infrastructure can make it hard for competitors to imitate.
- Alignment with the business model: A moat should support the company's strategy. For example, signing long-term exclusive fixed-price contracts for raw materials that can be easily and quickly substituted with cheaper ones without affecting quality and delivery time is unnecessary.
- Scalability: As the business grows, the moat must grow with it. For example, if McDonald's market cap triples, but the company can no longer buy, lease, and maintain its property, its real estate advantage weakens, leaving it more exposed.
- Tangible financial impact: A moat must positively impact financial metrics such as ROIC, ROE, Free Cash Flow, and others. It should protect profitability, not diminish it.
- Adaptability: Moats must remain effective as the business evolves. The emergence of new technologies and unstable consumer preferences are the key factors that tackle the moat.
- Barriers to entry: Investors should be able to clearly identify high entry requirements such as government licensing, strict regulations, time- and cost-consuming replicating of infrastructure, etc.
Many reputable investment funds apply this theory when building their ETPs by identifying companies with strong economic moats, such as Morningstar, Invesco, and WisdomTree.
Understanding economic moats provides investors with a powerful framework for identifying businesses with sustainable competitive advantages. Companies that successfully build and maintain these protective barriers often reward shareholders with consistent long-term returns that outpace the broader market.