You might hear references to an Economic Moat when reading value investing analysis for specific companies. What does a moat have to do with the fundamentals of a company? Before we answer that question let’s be clear on what a traditional moat from medieval times is. The dictionary definition is:
A deep, wide ditch surrounding a castle, fort, or town, typically filled with water and intended as a defense against attack.
The moat was a critical tool to prevent rival groups from invading and taking over their castle and treasure. The bigger, deeper, and wider the moat the harder the castle was to conquer. In value investing the concept of a moat is meant to reflect how well a company can fend off its competitors, and protect its profits. The bigger the competitive advantage the wider the economic moat that the company is considered to have.
If there are significant barriers to entry to the market the company is said to have a wide economic moat. An example of a company with a wide economic moat is the Potash Corp (POT). Potash Corp produces a plant nutrient used to increase the yields from fields used to grow crops. The nutrient is thought to be a key ingredient for farmers that they must use at some time or another. The reason for Potash having wide economic moat is not due to the demand for the nutrient, it is because of how difficult it is to mine for it. Potash, the nutrient, is only found in abundance in a couple of places in the world. In addition to that, the investment required to open up a new mine is about $2 billion. If the mine does not produce enough Potash it will be unprofitable, so there is the initial investment risk to start a mine and then there is the risk that it won’t produce enough of the nutrient to be profitable. Such high costs and risk are a significant barrier to entry that would deter other companies from jumping into the Potash market and compete for those profits. For those reasons POT is considered to have a wide economic moat.
If other companies can easily enter the same market with few costs or barriers to entry the company is said to have a narrow economic moat. Most software companies, for instance, have narrow economic moats. Practically anyone can hire a developer to create a software application at a low cost. There are virtually no barriers to enter the software industry. In fact, it is common for successful software to be copied or pirated, which easily erodes the profits from the original company.
Barriers to entry can be things like costs to enter a market, the strength of the dominant firm’s brand, government or industry regulations, patents, and client loyalty or costs of switching to the new firm’s products.
How to Use It
Determining whether a company has a wide or narrow economic moat is another way of saying that you are performing a competitive analysis for the company. You will need to assess the company’s core business, how it makes its profits, whether it would be easy for a competitor to replicate its business and take market share, and whether there is risk that it’s competitive advantage will erode over time.
When researching a company, you must also look at how its competitors in the same industry are performing. That analysis is key to determine how wide the economic moat is and whether your investment will be safe. Determining the economic moat is key to gaining confidence in how long the company can maintain its current level of profitability.