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What is an Economic Moat for a Stock?

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One of the well-tested assumptions of modern capitalist economics is that competition will eventually erode most business advantages. Consider the history of consumer electronics. One company will introduce a new product to make a lot of money with initial success, only to lose the market to many smaller competitors who develop cheaper, faster, simpler, or more available clones.

This commoditization (where a unique product available from only one vendor becomes an interchangeable product available from many vendors) spurs businesses to continue to invent new products to sell (until they're copied). If you're a customer, this is a good thing. Prices decrease as value increases.

If you're a business owner—or a shareholder of a public company—commoditization makes you work harder for the same revenue, whether inventing new products or finding ways to reduce expenses to retain your profits. You can't rest; someone else will come along and make it cheaper, faster, better, or different.

What is a Competitive Advantage?

A competitive advantage is something a company does which makes its business model difficult for competitors to disrupt. For example, an Apple phone may do the same thing (roughly) as a Samsung phone, but Apple has a competitive advantage in its very strong brand. People will wait in lines outside stores to buy a new phone when it's released.

A competitive advantage may be the execution of an idea. For example, Amazon is very, very good at shipping things quickly. Even though you could drive to your local store and get an item right now, sometimes it's easier to order online and wait two or three days for free shipping.

Amazon has a second competitive advantage, shared with Walmart: size. Both companies are large enough to dictate payment terms to suppliers and sell enough product that they're effectively getting short term loans from their suppliers in the form of inventory that's immediately sold with the profits invested in very short terms. Even a tiny amount of interest on a lot of money makes a lot of money.

A restaurant or food or beverage with a secret recipe—say that of Coca-Cola is another competitive advantage. To some people any fried chicken or cola will do, but to others, only the real thing is acceptable. Brand helps there too.

What is a Durable Competitive Advantage?

When you analyze a business, knowing about any competitive advantage and ranking it against other businesses will give you more information about the value and growth prospects of the company.

A durable competitive advantage is a business edge which keeps commoditization at bay entirely; it's something that can only be disrupted at great time or expense. A competitive advantage will eventually fall, but a durable competitive advantage is immensely stronger.

Think about the formula to Coca-Cola. A trade secret is an important competitive advantage, but it's also risky. If that secret were ever revealed, competitors could duplicate the flavor of a Coke and produce an exact competitor. Coca-Cola would still have the competitive advantages of its strong brand, its network of suppliers and bottlers and shippers, and all of those soda machines across the world. Its profits would probably go down though.

If the secret Coke recipe included a rare ingredient only grown on a single farm owned by the corporation, its competitors couldn't make an exact duplicate. Coca-Cola's advantage would persist.

This durability of competitive advantage has degrees. A patent (17 years of monopoly control over a device or invention) is less durable than a copyright (70+ years of monopoly control over a creative work). A trade secret is only as durable as it remains a secret.

What is an Economic Moat?

An economic moat is a durable competitive advantage which allows a business to maintain its profit over the long term against any competitors. Good and great competitors may exist, but this advantage in quality of product, brand, production, productivity, or execution which allows the company to out-compete everyone else. Warren Buffett coined the term "economic moat".

An economic moat is good for investors. It may be neutral or negative for customers; moats can produce monopolies and monopsonies, but they can also provide important information, such as brand quality. Coca-Cola doesn't have to spend a lot of time coming up with new flavors of soda which will be immediately copied. Everyone knows what they're getting with a Coke.

On the other hand, Amazon and Walmart do continue to invest in their logistics and inventory systems, because those moats do degrade over time.

A good moat can do many things. It can prevent competitors from appearing at all. While it's too expensive to start a business to go head to head against Amazon in general, you may have a store which successfully sells niche products and competes on selection, quality of service, or another non-logistical angle. It can also reduce the profit available to potential competitors, such as Standard Oil dropping prices in certain markets to make it not worth anyone's time to try to sell oil or gasoline.

A moat can even be a specific business process, such as Intel's tick-tock model of building a new fabrication plant for a new type of semiconductor and making it cheaper to get better yields out of it. Where a competitor may replicate the technology, it's unlikely to repeat the process of improvement at the same scale and quick timeframe, and will soon find itself selling obsolete products.

How Important is a Stock Moat?

Not every good company has a strong moat, but many companies with strong moats are owning. When you research good stocks, a durable competitive advantage is a major positive.

Paying the right price for a stock is still the most important factor in the profit you're going to make. Obviously companies with economic moats and undervalued stocks are worth considering. Knowing the long term business potential of a business—especially how a company can address competition and commoditization of its products or services—will help you find and buy great stocks.