Economic Moat: Learn Warren Buffetts investment style
A moat is a deep, broad ditch, either dry or filled with water, which is dug and surrounds a castle, fortification, building or town, historically to provide it with a preliminary line of defence.
What is an Economic Moat?
A moat is a deep, broad ditch, either dry or filled with water, which is dug and surrounds a castle, fortification, building or town, historically to provide it with a preliminary line of defence.
You will ask, how this is relevant in the stock market? Every successful business recognises that its biggest threat will come from competitors and that keeping them away is crucial to maintaining its supremacy. As competitors nibble away at their market share, companies are likely to witness a decline in their bottom line over time. That is why a company that wants to be dominant must create an economic moat.
The term "economic moat" refers to a company's competitive advantage resulting from a variety of business strategies that enable it to make above-average earnings over a long period of time. Competitive advantage that is difficult to mimic or duplicate (brand identity, patents) and thus creates an effective barrier against competition from other firms.
Buffett on the moat
Warren Buffett explained his moat principle at the 1995 Berkshire Hathaway annual meeting of shareholders.
"What we're trying to do," he explained in response to a question from the audience, “is we're trying to find a business with a wide and long-lasting moat around it, surround -- protecting a terrific economic castle with an honest lord in charge of the castle."
He went on to say that a corporation with a moat must have the following characteristics: "What we're trying to find is a business that, for one reason or another - it can be because it's the low-cost producer in some area, it can be because it has a natural franchise because of surface capabilities, it could be because of its position in the consumers' mind, it can be because of a technological advantage, or any kind of reason at all, that it has this moat around it."
When he's found a business with a large moat around it, the next stage in Buffett's process is to try and figure out what's keeping the moat intact:
"But we are trying to figure out what is keeping -- why is that castle still standing? And what's going to keep it standing or cause it not to be standing five, 10, 20 years from now. What are the key factors? And how permanent are they? How much do they depend on the genius of the lord in the castle?"
After Buffett and Charlie Munger have established the aforementioned characteristics, the next step is to determine the company's manager's capability: "And then if we feel good about the moat, then we try to figure out whether, you know, the lord is going to try to take it all for himself, whether he's likely to do something stupid with the proceeds, etc."
Essentially, the wider the economic moat, the larger and more sustainable the competitive advantage of a firm.