How to Find Wide Economic Moat Companies
An Economic Moat is a long-term competitive advantage that creates a market barrier to other firms and can enable a company to maintain very high profit levels. The term “economic moat” was coined by the great investor Warren Buffet who believes that investing in a company with a substantial economic moat is safer than investing in companies that are more open to the threat of competition. Buffet’s argument is supported by the economic theory that states when markets are perfectly competitive, competitors will eventually take away the excess profits of a business. While having an economic moat does not ensure the success of a company, it can make it difficult to displace that company as the industry leader.
Types of Economic Moats
While there are a number of ways that a company may develop and economic moat, some of the most common include:
Product Differentiation: A company that produces a product that offers superior technology or features has a distinct advantage over its competitors. Actually, the product only needs to be perceived to be the best in order for the company to obtain this advantage. This type of economic moat is considered “narrow” as advancing technology and changing consumer preferences can render this a short-lived advantage.
High Switching Costs: A customer is less likely to leave if there are high costs or a high level of inconvenience associated with leaving. If the customer has undergone a significant amount of training on the product and would need to be trained on a new product, this can also deter a switch.
Locking Out Competitors: Companies that hold patents on lucrative products are among those with the widest economic moats. Drug companies provide a good example of this type of moat. Companies that operate in highly-regulated markets (e.g. utilities) also enjoy this type of advantage.
Low Cost Provider: Offering a comparable product at a lower price can provide a decisive advantage. This advantage is obtained by those companies that have developed a better process or operate on a larger scale. This type of moat can also be considered narrow, though, as competitors often find ways to match prices.
Finding Companies with Wide Economic Moats
Many analysts will tell you that finding companies with wide economic moats is more art than science- meaning it is largely about judging qualitative factors. While this may be true, there are quantitative factors an investor can look for in finding wide moat companies, including:
High return on invested capital
Strong earnings growth
High profit margins
Strong free cash flow
High return on assets
High return on equity
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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