A business’s moat refers to its ability to maintain the advantages that are expected to help the company stay ahead of industry rivals and maintain excess profits into the future. Traditionally these are deeply ingrained benefits like owning a great deal of intellectual property, enjoying a lower cost of capital, a network effect, and/or brand recognition. This combination of tangible and intangible assets will protect a company’s market share as other players and new competitors find it difficult to copy or emulate.
The term “economic moat” was popularized by legendary investor Warren Buffett, the chairman of Berkshire Hathaway. His definition refers to when a company shows a sustainable competitive advantage due to assets built up over a long period. A company with a strong moat possesses a competitive advantage that is both strong and sustainable.
If a business has little to no competition there is probably a good reason for that, either the market is too small for competitors, or management has built a great economic moat around the company. The strategies that create a moat to shield a company from competition come in two broad categories; strategies that make it expensive for competition to enter a market, and strategies that make it difficult to gain market share.
Intellectual property and regulatory barriers are a major economic moat for established businesses that make it difficult to enter a market. Patent holders that have the capital to sue newer, less well funded, market entrants can stop competition. In highly regulated markets, companies need to get cleared and licensed to operate, which can be an expensive and time-consuming process. The risk of investing in this setup cost will also slow down or prevent competition. Also, any type of business that requires a large up-front capital investment, or requires a specialized skill has a natural economic moat. The first movers or ones with access to cheaper capital can take advantage of this to prevent others from entering a market, which reduces competition.
Some strategies make it difficult to compete. A great reputation and brand help sustain an advantage over comparable businesses. A strong brand for quality and reliability works by taking up mindshare, which means when customers don’t want to bother researching options because it is the first thing that comes to mind it becomes the default option. Also, in purchases with big downside risk, a brand known for dependability will make it costly for customers to switch, so they will not risk it by going with a lesser-known product or service.
Many businesses have a deliberate strategy of integrating with the customers’ systems in such a way that it makes it difficult and costly to switch. High switching costs are a great moat that keeps other industry players from taking market share with lower prices or better quality. This is a strategy that businesses have more control over. The advantages and benefits of switching have to be significant to make the hassle worthwhile. One strategy in B2B SaaS services is to offer free training so employees get used to their system. Businesses that get customers signed up into long-term contracts also make it difficult and expensive to switch and for competition to enter the market. Either contract or a business based on relationships can prevent a competitor from taking market share.
Finally, a business has a technical advantage, enough scale, or institutional knowledge that makes it difficult for a smaller firm or new market entrant to compete. Sometimes established businesses do have trouble shifting operations when the business landscape changes, but generally this is a major moat. Economies of scale help a company provide the same product or service at a lower variable cost. And institutional knowledge or innovation in the production process that provides lower costs and better gross margins than anyone else can make it difficult to compete and a durable economic moat.