Understanding Economic Moats

Over the past couple of weeks, I’ve been curious about Economic Moats and the role that they play in investing and entrepreneurial strategy. This started when Andreessen Horowitz did a great couple of PodCasts on Network Effects (first, second), and below is what came out of my subsequent reading and research. This is by no means an exhaustive study on Economic Moats, just an overview that I hope that you’ll find useful.

An Economic Moat is fundamental aspect of a business that allows it to consistently create outsized returns from capital investment over the very long-term. It is not simply a competitive advantage (which is often superficial and fleeting), it is structural and often has to do with the underlying business model.

The focus on the long-term is important here… a business can have short-term returns that are much higher than those that are needed to signify an Economic Moat (say, incredible growth due to a new product launch), but those returns in and of themselves are not sustainable. An Economic Moat is fundamental to the business, and therefore lasts.

Typical types of Moats include: Intangible Assets (like brands & patents), Customer Switching Costs (think cell carriers…), Network Effects (on my list to do a full post on network effects), and Ingrained Cost Advantages (like proprietary processes & the effects of scale).

Interestingly, while many believe that an amazing management team can be an Economic Moat, Pat Dorsey (one of the main value-investors who helped coined the term) doesn’t believe so. The team is important, but simply not a structural aspect that represents a Moat.

One key insight I found came from the venture investor Brian Laung Aoaeh of KEC Ventures. It is that Economic Moats happen to a business, they aren’t intentionally created. There certainly will be business models, products or industries that are naturally disposed to have the potential for Economic Moats to happen, but they are far from guaranteed. Economic Moats simply describe the situation that a business finds itself in… they are not a strategy, they are the result (most often unintended) of a great strategy that was seriously well executed.

The theory of Economic Moats is about judging the value of existing businesses for investment purposes — or in the case of startups: the value potential IF a Moat happens. Which becomes obvious when you think about how the value-investing giants Warren Buffet and Pat Dorsey coined the term.

The advice, therefore, is that Entrepreneurs shouldn’t focus on creating Economic Moats… as always, they should only focus on creating an amazing product experience for his/her customers, in order to solve a problem that the Entrepreneur cares about.

And if you think about it, that makes sense. For instance, you can’t create the swell of usage that results in an Economic Moat, without first having an amazing product that provides a breakthrough experience for its users. The product comes first, Economic Moats simply fall out after flawless execution (if they’re meant to be). Entrepreneurs in the early stages need to understand Moats, but only to be able to recognize them for valuation.

So, there you have it. A bit about Economic Moats, and the role that they play in investing and entrepreneurial strategy: they are super powerful tools for valuation, but they aren’t a business strategy… they are the result.

Below are four presentations / articles that I found useful in understanding Economic moats deeper than I had in the past. If you have time and the inclination, definitely check them out.

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Deeper Reading #1

An overview of Economic Moats, and how to think of them as an investor, by the investment professional who popularized the theory, Pat Dorsey.

“An economic moat is a structural business characteristic that allows a firm to generate excess economic returns for an extended period.”

Deeper Reading #2

A presentation by Brian Laung Aoaeh, who writes the blog Innovation Footprints. It’s a 79 slide deck delving fairly deeply into all aspects of economic moats from the perspective of technology startups and seed investing.

“An economic moat is not the same thing as a competitive advantage. A competitive advantage is temporary. A durable economic moat is unique, and typically can not be duplicated.”

Deeper Reading #3

A follow-up piece from Brian Laung Aoaeh, clarifying that entrepreneurs should not focus on trying to create economic moats, he believes that they happen to a business.

“My interest in studying economic moats is so that I can recognize those instances in which the probability that they emerge is high, whether naturally or by accident. Seed-stage technology startups with a high potential for economic moats to eventually emerge are the ones that I personally find most attractive as potential investments.”

Deeper Reading #4

This is an interview with Pat Dorsey from 2015, where he discusses how his investment theories have evolved since his formerly pure focus on Economic Moats. For him, Moats are great, but not necessarily enough… he also needs to see strong management (not a moat, but important) and compounding potential (i.e.: natural organic growth that comes from smart re-investment of capital).

“Every time you make an investment, in fact every time you make a decision, write it down. It’s very easy with the hindsight bias to rationalize that decision when things don’t go in the right direction,” says Dorsey. “Then you can pull that out three months later, one year later, and say — does reality today match what I thought it would be?”