“The term economic moat, popularized by Warren Buffett, refers to a business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms. Just like a medieval castle, the moat serves to protect those inside the fortress and their riches from outsiders.” — Investopedia.
The ‘Oracle of Omaha’, Warren Buffett has been famously advocating the importance of “Economic Moat”. Buffet seeks out companies with a sustainable competitive advantage which in turn allows for high profits and discourages from new entry.
As an investor, we want to identify companies that resemble a fortress. We want the company to continue generating profits and cash flow, even in times of a market bloodbath. The share prices of such companies often have a low standard deviation and provide consistent dividends to their shareholders.
3 Characteristics of a company with an Economic Moat:
1. Switching Cost
A company with a deep moat will have products and services that deter their customers from switching to their competitor by enforcing high switching cost. This cost may not only be a monetary cost, but also intangible value to the consumer. An example is the Operating System (OS) that mobile phones use. Currently, the two main players are Android and iOS. Switching from one OS to another would mean that the user will have to relearn the basic phone features and interface operations. Previous data from the native apps might be lost as well with the switch.
This creates a trap in the ecosystem for users of a specific OS. Furthermore, with the convergence of the market, it forces other players like BlackBerry and Windows to exit the phone OS market altogether.
Government regulations may sometimes play an important role in determining which firm will reign supreme in a particular industry. Policies are written by the government to control the barrier to entry in particular industries. In the case of Singapore, the print media is dominated by Singapore Press Holdings and MediaCorp.
These companies have to meet the stringent criteria from Info-communications Media Development Authority (IMDA), in turn, giving them regulatory moats and deterring new entrants.
3. Network Effect
Additional users of a product or service would cause a positive effect on the value of that product to others.
This is evident in messaging app platforms. Chances are the choice of your current messaging platform is determined by what most of your social circle of friends are using. WhatsApp in Singapore, WeChat in China and Line in Taiwan. Being the dominant player, companies can integrate other products or services, like WeChat Pay, to leverage on the deep userbase.