Economic Moat Definition: 5 Types of Economic Moats

An economic moat is a company's competitive advantage over rivals due to deeply ingrained benefits like owning a great deal of intellectual property, enjoying a lower cost of capital, a network effect, or brand recognition. This combination of tangible and intangible assets can buttress a company's market share for years or even decades, as competitors struggle to cross the metaphorical economic moat.

The term “economic moat” became popular in the broader business lexicon via Warren Buffett, the chairman of Berkshire Hathaway Inc. It applies whenever a company shows a sustainable competitive advantage due to assets built up over a long period of time.

Consider some of the ways an economic moat can shield a company from meaningful competition.

1. 1. Access to capital: Companies that are publicly traded on the stock market may enjoy a relatively low cost of capital that allows them to borrow money for new investments. This can keep their facilities, and their research and development endeavors, ahead of the pack for long periods of time. While a publicly traded company's financial performance is carefully tracked, investors may not demand profitability for years. Privately-owned small businesses rarely have such a luxury.
2. 2. Network effect: The network effect is the phenomenon of customers switching to a brand to interact with customers already using that brand. Examples include someone getting a cellphone that’s compatible with their friends’ phones or a seller listing a product on a large e-commerce site to access its vast network of buyers.
3. 3. Switching costs: Shifting your business from one company to another can come with high switching costs. These costs can be both tangible (money spent to switch) or intangible (new learning curves, time spent on administrative tasks). This phenomenon explains why insurance companies, telecom providers, and computer operating systems often have wide economic moats.
4. 4. Economies of scale: When large companies process millions of transactions, they can enjoy lower costs for each transaction and then pass the savings along to customers in the form of low prices. This helps massive retailers sell goods for prices that would send a smaller brand into bankruptcy.
5. 5. Name-brand recognition: Customers become loyal to brands, and they can be hard to pull away. In some cases, the valuation of a brand name is as meaningful as the goods or services that the brand provides.

Economic moats exist in many sectors of the economy.

1. 1. Retail: Big box stores enjoy wide economic moats due to economies of scale, meaning they can buy large amounts of inventory for low prices and pass the savings along to customers. They also often have reliable supply chains. They leverage these advantages into a business model that prices out smaller competitors and retains customers with low prices and wide product selection.
2. 2. Dining: Fast food restaurants operate at low profit margins, which smaller mom-and-pop restaurants often cannot maintain. By operating at a large and efficient scale, they enjoy many millions of low-margin transactions that add up to great profits over an extended period of time.
3. 3. Legacy brands: Famous brand-name companies can experience years of sustainability based on their multi-decade reputations. This grants them a cost advantage over upstart competitors that might need to scramble to introduce their brands to potential customers.
4. 4. Computing: Large computer companies and software companies enjoy economic moats created by network effects. When a large number of customers use a product or a service, they bring in and retain other customers who need those same products and services to interact with one another. The larger the customer base, the better the service works. Scrappy startups may have a hard time peeling away customers from these brands, which would require the customers to abandon parts of their networks. When it would be too inconvenient to abandon an established company, that company also has what’s known as pricing power.
5. 5. Insurance: It’s common for customers to stick with their existing insurance policies—whether it’s health insurance, homeowners insurance, or car insurance—because of the high switching costs of changing providers. These switching costs do not have to be monetary to be significant. In many cases, they describe the hassle of the administrative tasks that go along with switching providers.

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