One of Warren Buffett’s investment rules is to only invest in companies with an economic moat. So what exactly is an economic moat?
“In business, I look for economic castles protected by unbreachable ‘moats’.” – Warren Buffett
Simply put, the metaphoric “castles” are companies and the moats around those castles are special qualities that they possess. Warren looks for qualities that provide the business with certain advantages; qualities that protect it from its competitors – just like moats that protect their castles.
You can look at the competitive advantages of a company to determine whether it has a moat and how wide its moat is. Competitive advantages are certain qualities that a company has that allows it to generate more sales, achieve superior margins and retain higher amounts of profits compared to its competing firms. It is an edge over its competition and allows the company to increase or maintain its market share over a long period of time.
Basically, the more numerous/ sustainable the company’s competitive advantage is, the wider its moat is. A competitive advantage is usually one of 2 types. Comparative advantages or differential advantages.
A comparative advantage is an advantage usually created by a company’s ability to produce goods at a lower price than other competing firms which means that they can undercut rival companies through pricing their products at prices so low it makes no sense for their rivals with higher costs to sell their goods at the same price. For example, Amazon, through its partnerships/ acquisitions, is now able to ship products at such efficiency that is almost impossible for other companies to replicate.
A differential advantage is, as its name suggests, an advantage created by being different. Either through some great innovation or research and development, a company with a big moat is usually able to create products or services that set them apart from other companies. For example, patents are considered as moats because it allows the firms that innovate to profit from their creativity for an extended period of time. Even a built up brand name like Coca Cola or Apple can be considered as a moat because of their reputations for consumer products.
Warren Buffett likes to invest in companies with economic moats that are as wide as possible.
We think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business… if the moat is widened every year, the business will do very well. – Warren Buffett
By investing in companies with economic moats, you can ensure that the companies that you invest in will always have superior returns in the long run.
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