Warren Buffett defines an economic moat as something that gives a business a unique, enduring advantage over competitors that protects its profits and market share. It can be in the form of pricing power, toll booth-like qualities, or qualitative brand name value. The wider the moat, the better, and in Buffett's world, he prefers companies that work yearly to increase the size of their moat -- and if they can throw sharks in the water, so much the better.
Buffett has elaborated on this idea in the past by describing the challenges one would face trying to overcome the moat of Coca-Cola (NYSE:KO): "If you gave me $100 billion and said, 'Take away the soft drink leadership of Coca-Cola in the world,' I'd give it back to you and say it can't be done."
Understanding this economic moat is imperative to investing success for Buffett, as he prefers to buy businesses within his circle of competence that have sustainable competitive advantages, along with rational management and a good price. We can further define this moat by illustrating first what it is not.
A thin moat of hard root beer
The story of Not Your Father's Root Beer is the antithesis of the moat. This brand of alcoholic root beer, produced by craft brewer Small Town Brewery, rocketed to sales of over $85 million, representing 1.95 million cases, this past summer and became the No. 1 selling craft package of 2015. It seemed to come out of nowhere, but in reality, the beer was created in 2012 and became widely available across the U.S. in early 2015.
In a moat-diminishing move last July, Boston Beer released its own Coney Island Hard Root Beer, snatching up 18% of the market, according to IRI data. Further shrinking the moat this past December, AB InBev joined the fray with its Best Damn Root Beer.
As larger competitors with more resources for marketing and distribution enter this niche drink category, they illustrate precisely what an economic moat is not: a product that can easily be copied. Small Town Brewery's 2016 is unlikely to resemble its stellar 2015.
A wide moat filled with Coca-Cola
Contrast the above situation with that of the granddaddy of all moat builders, Coca-Cola.
Arguably, even though the formula for Coke is top secret, a sugar-injected, carbonated beverage can easily be copied (Pepsi, anyone?). Author Mark Pendergrast even published the purported original formula in his book For God, Country, and Coca-Cola.
But when Coca-Cola executives took away the original Coke formula in 1985 and replaced it with New Coke, it was discovered just how deep this recipe ran with loyal customers. Letters and calls to a dedicated complaint hotline flowed in like a tipped-up two liter:
- "Changing Coke is just like breaking the American dream, like not selling hot dogs at a ball game."
- "Would it be right to rewrite the Constitution? The Bible? To me, changing the Coke formula is of such a serious nature."
- "There are only two things in my life: God and Coca-Cola. Now you have taken one of those things away from me."
In many ways, by introducing New Coke, Coca-Cola had assaulted the nostalgic memories of many of its customers, and in July 1985, less than three months after the introduction of New Coke, the company reintroduced the original formula as Coca-Cola Classic.
Many alternatives exist to the carbonated sugar beverage, but in the minds of consumers, there is only one Coke. The recipe defines half the moat the company enjoys -- the other half can be attributed to the company's brand.
Of Santa Claus and The Saturday Evening Post
Atlanta pharmacist Dr. John Pemberton created Coca-Cola in 1886, and since its inception, the beverage has been featured on millions of items, ranging from baseball cards to matchbooks and music to film. It was also featured in The Saturday Evening Post, and every Christmas, artist Haddon Sundblom would produce a new ad for the drink featuring an image of Santa Claus that would come to define his modern-day look.
Over a century of brand building later,Coca-Cola has become as synonymous with the United States as the American flag for many. That kind of recognition makes for a formidable moat.
As a result, Coca-Cola stock has delivered a solid earnings growth and a return on equity that has averaged 30% over the last 10 years. With 400 million shares, Coca-Cola is also one of Berkshire Hathaway's largest stock holdings.
A tale of two moats
The moat of Coca-Cola runs contrary to that of hard root beer: The recipe at Small Town Brewery rests on four years of brand building, and imitators have already surfaced. Its moat has been traversed, and the encroachers have filled it in with concrete. Coca-Cola, by contrast, rests on 125 years of brand building and occupies prime real estate in the minds of consumers. This is not something that can be replicated in just one summer -- even the world's greatest investor wouldn't take that challenge.
The message for readers is this: When looking for a superior investment with an economic moat, stay clear of businesses whose chief product can easily be substituted and replaced in the consumer's conscience. Keep in mind as well that economic moats come in a variety of flavors, including purchasing power or toll booths -- think Wal-Mart and GEICO, respectively.
The moat of patented recipes and mental real estate is a primary flavor, and its main ingredient is Coca-Cola.
Adam Brownlee owns shares of Coca-Cola and Wal-Mart Stores. The Motley Fool owns shares of and recommends Boston Beer. The Motley Fool recommends Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.