The term “economic moat” was coined by Warren Buffett.

Think about a castle that is surrounded by a deep trench, a moat, filled with water. The moat acts to protect the castle from invaders, and the bigger the moat, the less of a chance attackers have of getting across the moat!

Moats, in the context of investing, allows a company to outearn and fend off its competitors for as long as the moat is intact. Just like a castle, the wider and deeper these moats are, the harder it is for competitors to replicate, the less of a chance they have of seizing market share.

Moat investing is based on a simple concept:

Invest in companies with sustainable competitive advantages trading at attractive valuations.

One of the first steps in implementing this approach is finding companies with a moat. A company’s moat refers to its ability to maintain the competitive advantages that are expected to help it fend off competition and maintain profitability into the future.

Moat archetypes

While Moats come in different shapes and sizes, they can be categorized into five distinct archetypes (you can find a more comprehensive explanation with examples in this VanEck Report).

1. Intangible assets (e.g. SBUX) – Patents, brands, regulatory licenses and other intangible assets can prevent competitors from duplicating a company’s products, or can allow the company to charge a significant price premium
2. Network effects (e.g. GOOG, MSFT, V) – As more people use a company’s product or service, the value of that product or service increases for both new and existing users
3. Switching cost (e.g. CRM) – When it would be too expensive or troublesome to switch away from a company’s products, that company often enjoys pricing power
4. Low-cost producer (e.g. WMT) – Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or can charge market-level prices while earning relatively high margins
5. Natural monopolies – (e.g. D) When a company serves a market limited in size, new competitors may not have an incentive to enter. Incumbents generate economic profits, but new entrants would cause returns for all players to fall to a level in line with or below the cost of capital

Key Takeaways:

• A company is a good investment if they earn and can continue to earn more than what they’re selling for. The greater the earnings are compared to the price, the better the investment.
• A moat is a distinct and structural advantage a company has that is difficult to replicate and are what allows a company to earn lots of money. The stronger the moat, the more money it earns.
• The longer you hold a company with a strong moat, the better your return on investment will be.
• Identifying a moat is not rocket science — understand how the company makes money, figure out why consumers prefer their products over their competitors, and cross-reference your hypothesis with a few key numbers.
• Owner's earnings growth is a good and reliable way to identify if a company has moat. The wider the moat, the more owner's earnings will grow.

Interested to hear examples of companies with wide moats in each of these archetypes, so feel free to share in the comments.