The concept of the economic moat comes from Warren Buffett, an American businessman and one of the most successful investors in the world. The term refers to a company's ability to maintain a competitive advantage over its rivals and thus protect its long-term profitability and market share. Buffett's investment strategy centers on companies with strong economic moats, as they are more likely to withstand their competitors and remain successful.
Why companies need a competitive advantage
A competitive advantage is any quality that enables a company to offer similar products to its peers while enjoying superior financial performance. Over time, companies are more likely to lose their competitive advantage because, as they grow increasingly profitable, competitors are more likely to replicate their methods or create even better ones. Establishing economic moats can help companies protect their long-term profits. There are several ways in which a company can create an economic moat, and it's possible for a company to have more than one.
Cost advantage
Companies that can deliver or produce their goods or services at a low cost have a major advantage over the competition, because they can undercut their competitors on price. Companies with long-term sustainable cost advantages can command and maintain a large market share within their respective industries, thus forcing competitors out. Wal-Mart is a good example of a company that maintains a cost advantage, in part by buying and selling huge volumes of goods. Meanwhile, Apple leverages its brand power to squeeze lower prices out of its suppliers, which are eager to deal with this titan of consumer tech.
The network effect
The network effect occurs when the value of a good or service grows as more people use it. A good example of the network effect is eBay, whose ever-growing user base offers continuous value to buyers and sellers.
High switching costs
Switching costs are expenses or disruptions a customer will encounter when switching from one product or service to another. It's beneficial for companies to create high switching costs, as doing so can help them retain customers. Cellphone service providers, for example, can lock in customers because of their high switching costs. To change providers, a customer might need to terminate an existing contract and purchase a new phone, both of which can be costly. As such, customers might be less motivated to switch providers even if they are dissatisfied with their current service.
Intangible assets
Some companies have a distinct advantage over others due to their intangible assets, which include patents, licenses, and brand recognition. If a company establishes a well-known brand name, then it can charge a premium for its products or services. The perfect example might be Nike, which started out as a simple athletic-apparel company but has since become a major cultural institution and a purveyor not only of gear, but of status. Designer fashion labels have similar business models, using their prestige to sell clothing for prices several times higher than the cost of production.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected]. Thanks -- and Fool on!
