What are Economic Moats?

An economic moat meaning refers to a structural advantage of a company that helps it to maintain profitability, often through inimitable assets. Usually, a company’s moat revolves around its brand value, cost advantage, unique products, and customer loyalty.

It refers to a company's ability to maintain a competitive edge over its competitors in protecting its market share and long-term profitability. Investments based on these attributes are supposed to be more reliable and generate steady returns in the long run. The term economic moat was widely popularised by Warren Buffett.

 

Types of Economic Moats

Here are the key types of economic moats you must know:

 

1. Cost Advantage

Low cost is often seen as an advantage by customers. Hence, companies that can produce goods or services at a lower cost enjoy a cost advantage. Reliance Industries leverages its scale to maintain low costs.

 

2. Brand Value

A strong brand value provides an unmatched competitive advantage as it takes years to build trust and is very hard to imitate by competitors. They possess a high level of customer loyalty and can charge a premium for their products. Brands like HDFC Bank and Tata Motors command economic moat due to their brand values in respective sectors.

 

3. Network Effect

The value of a company grows exponentially with the increase in user base. Some of the companies thriving under the network effect are  Zomato and Paytm. These platforms have grown by attracting more customers and merchants simultaneously.

 

4. High Switching Costs

Switching companies for products or services often becomes a hassle for customers when it’s not smooth or comes at a high cost. This helps companies in retaining their customers from their competitors. TCS and Infosys, due to their deep integration with client systems, have this advantage.

 

5. Toll or Monopoly Advantage

When companies are sole suppliers of any product or service, they are considered to have a toll or monopoly advantage. These types of businesses are safe and often considered profitable in the long run. For instance, Pidilite Industries is considered a market leader in its business segment and enjoys a near monopoly status.

 

How to Choose Investments Based on Economic Moats

Here are all the indicators you can take into consideration when choosing investments based on Economic Moats:

• Strong Performance under all Economic Conditions: Companies with an economic moat show good performance even in economic downturns due to their unique advantages. For example, Asian Paints showed consistent performance even during the pandemic.
• Consistent ROE and ROCE: Two indicators of profitability can be a consistently high return on equity (ROE) and return on capital employed (ROCE). This signifies profits are generated by the efficient use of resources.
• Position in the Industry: The company’s market share compared to its competitors gives a fair indication of its competitive advantage. Companies operating in an industry with a high entry barrier will enjoy a strong economic moat.
• Unique Business Model: Companies having unique business models will succeed over their competitors in the long run. Brands, patents, and proprietary technologies give a competitive edge to companies.

 

Conclusion

Choosing investments based on economic moats can be a smart strategy for building a robust portfolio. According to Buffett, “A good business is like a strong castle with a deep moat around it.“ If these moats are strong, your investment will be safe and full of returns.