An economic moat refers to a company’s ability to withstand competition for its products and services, just as moats used to protect castles from attack. The “wider” the moat, the bigger the company’s competitive advantage.
One of the cornerstones of Warren Buffett’s investment philosophy has been to buy the shares of companies with exceptionally wide economic moats – although Buffett is often described as a value investor, both he and his business partner Charlie Munger have often said that it is better to buy a great company at a fair price than a fair company at a great price.
Moats come in various guises, but they all make it difficult for competitors to take away a company’s customers. For example, a company may be the lowest-cost producer of a product, or it may have a patent on a technology or manufacturing process. Strong brands are also seen as a form of moat because customers have a high degree of conscious or unconscious loyalty to them (Coa-Cola and Pepsi essentially sell flavoured fizzy water, but remain dominant and highly profitable in their sector).
One way to spot a company with a wide moat is to look at its financial track record. If you can see stable and growing profits, high profit margins and a high return on capital employed (ROCE), then you may have identified a company with a moat. Of course, you then have to work out whether this moat can continue to withstand attacks.
The shares of companies with moats tend to be quite expensive and they can still be bad investments if you pay too much for them. However, sometimes you can pick them up for a decent price during times of stockmarket panics or crashes.