Protect The Castle — Explaining Economic Moat

“So, do you know what Economic Moat means?”

I didn’t, of course. But it was an interview, so I did what people do — lie.

“Ya, I understand it… just not that well.”

Most people don’t know what economic moat means. Even business people and investors are unfamiliar with it. But although it’s relatively unknown, it is important. So just incase you get asked in an interview, as I was, this is a simple explanation:

Economic moat is a sustainable competitive advantage.

A Company is a Castle

Think of a company as a castle. The wider the moat surrounding the castle, the harder it is for others to attack it. The moat creates a barrier. Any successful company has to deal with attacks from other companies as they attempt to steal market share. The greater a competitive advantage a company has, the harder it is for others to chip away at their position.

A competitive advantage is a characteristic that is difficult to recreate. Maybe that means the company makes elite products, has unbeatable locations, or is a global brand. The big leap between a competitive advantage and an economic moat is sustainability. An amazing product can be copied…unless it has a patent. Then it becomes an economic moat. A product is a gentle stream; a patent is a treacherous river.

An amazing product can be copied…unless it has a patent.

When buying a company, it is imperative to use a long term mindset. You don’t buy a company because it is successful today; you do so because it will prosper for 10–20 years. To be successful long term, a competitive advantage won’t cut it. Competitors will chip away at market share. Companies need economic moats.

Making More Money

A company with a wide economic moat is able to generate more profit. The operations and practices used creates a greater Net Profit Margin for the company (Net Profit Margin is the amount of revenue that ultimately becomes profit).

Consider two competing phone case companies, A and B. They both create the same cases, have the same quality service, and have the same price. Company A has 5 employees, while company B has 4. In this case, company B would pay less wages. Therefore, they have a greater Net Profit Margin, as more of the revenue ends up as profit. You would rather own company B, and make more profit.

Company B is doing something better than company A. Let’s say they use an apprentice system. When company A finds this out, they too will implement an apprentice system. Before long, company A will only need 4 employees as well. In this case, company B doesn’t have an economic moat, just a competitive advantage. However, if company B has a one-of-a-kind manufacturing tool that produce cases faster, company B’s advantage is sustainable. An economic moat is present.

Intel (INTC) is a company with a wide economic moat built through their operations. They created a superior product, and now supply them to all computer companies. Any business using a computer (aka all companies) relies on Intel products unintentionally. This massive supply has allowed Intel to keep costs low (economies of scale), and have a high Net Profit Margin. Other companies would need to build a better product, and convince companies to switch over, for Intel to fail. Realistically, the change-over cost is too great for most companies to even entertain switching. Intel has become a necessity in the world today. Their market share cannot be easily eroded by competitors.

Spread Size

When people order at a restaurant, they ask “Can I have a Coke?” If the restaurant doesn’t have it, the server apologizes, and asks if a Pepsi will do. Coke’s brand is so strong that people use it as the default drink of choice! Coke is to soft drinks what Kleenex is to tissues or Nike to runnings shoes. When a brand becomes almost synonymous for the product, consumers clamour for it. Such brand strength creates an immense economic moat.

Because of the strength of their brand, Coca-Cola (KO) can charge high prices. Even though there are many similar options to choose from, consumers want Coke. This creates pricing power. When Coca-Cola charges a higher price, they create a greater ‘spread’. The cost of manufacturing their product may be comparable to other companies, but the amount they sell for is much higher.

Coca-Cola doesn’t compete on price. They compete on brand.

A generic brand may produce their drink for $0.50, and sell it for $1.00. They pocket $0.50 per $1.00 sold, so their Gross Profit Margin is 50%.

Coca-Cola may produce their product at the same cost of $0.50, but they can sell it at $2.00 because of the desire for the brand. Their profit is $1.50 per $2.00 of revenue, so the Gross Profit Margin is 75%. Coke has a greater ‘spread’ between the cost of good and the selling price.

Coca-Cola doesn’t compete on price — they compete on brand. And their brand is unbeatable.

Capital Intensity

You’ve just won the lottery, and want to buy a company. Two companies come to you to ask for funding. Both companies do the same thing and make the same amount of money. However, one of them needs less of your money, as they figured out a way to extend the machinery lifetimes. Wouldn’t you buy into the cheaper company?

Companies that need less capital (funds from debt and equity) to operate are preferable. A company with the unique ability to generate more profit from less money has an economic moat.

Apple (APPL) does not need much capital to generate a lot of income; production of their products is relatively inexpensive, allowing them to keep PPE (Property, Plant, and Equipment) low. They therefore retain cash and reinvest in R&D, allowing them to stay ahead of the competition.

Less reliance on capital also grants Apple greater flexibility. If bad economic times hit, Apple will not have their money tied up in assets, instead holding it in cash. This leaves Apple less exposed to market factors. Furthermore, if a new technology comes about that makes certain Apple products obsolete, throwing out their old equipment is not too great a burden. They will also have the cash necessary to facilitate a production overhaul. Apple’s ability to avoid investing their cash into capital expenditures such as PPE provides them a sizeable economic moat.

The Moat Matters

No matter what a company does, it needs to have an economic moat to survive long-term. Consider Blackberry: they had a competitive advantage with their full keyboards and safe network (Blackberry Messenger). However, they couldn’t make the competitive advantage sustainable, as the keyboard was jumped by touch screen technology and the network was re-created by competitors. In the end, Blackberry wasn’t able to keep its market share because it wasn’t unique.

Intel, Nike, Coke, Facebook, Apple… these companies are untouchable. Their brand strength, strategy, and operations allow them to make more money and serve more clients than competitors. It is unfathomable to imagine any of these companies collapsing any time soon.

Pick the protected castle and stay put. Royalty reaps the reward.

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Know a company with a wide economic moat? Think moat is overrated? I’d love to hear from you!

Comment below or send me an email at daniel@vuru.co

-Daniel Baum, Community Manager, Vuru