Economic Moats: Why They Matter

As part of their research, many investors seek companies with strong economic moats. These firms' sustainable competitive advantages often give them a leg up over the long term, potentially providing more stable returns even as market conditions evolve.

This article will unpack what economic moats are, how they're built, how they can erode, and why they matter to investors.

An economic "moat" describes a company's ability to fend off its competition and protect its profits and market share—not just now, but well into the future.

The term compares companies to medieval castles, which often used moats for protection from attackers. Just as a wide moat helped keep enemies at bay back then, a "wide" economic moat makes it harder for competitors to challenge a business.

Economic moats can come from various sources, like brand strength, regulatory barriers, or simply size and scale (more on this later). Companies with wide moats can often sustain higher returns on invested capital (ROIC) due to their ability to stay ahead of competitors over the long term, while those "narrow" moats are potentially at risk of seeing their competitive advantages erode.

Famously popularized by Berkshire Hathaway's Warren Buffett, and then formalized by analysts at Morningstar, this concept has become a central part of fundamental analysis. It provides investors with a framework to define and evaluate which companies' competitive advantages might give them a better chance of outperforming over the long term.

Most businesses want to create economic moats that help ensure their profitability and market share are protected for years to come. Achieving this isn't always easy, but there are a few ways businesses attempt to dig deeper and wider moats to protect their proverbial castles.

• Size and scale. Larger companies can often produce goods or offer services at lower prices due to their ability to spread fixed costs across more sales. Their scale can also help create bargaining power with suppliers, stronger brand recognition, and pricing power.
• Brand strength. Strong brand loyalty and trust can make consumers more likely to buy a company's products or services. Sometimes this allows companies to charge higher prices and keep their existing customers even if cheaper, similar-quality products or services exist.
• Switching costs. Companies can gain pricing power if customers find it's either costly or difficult to switch to a competitor's offerings. Barriers to product switching include things like long-term contracts, loyalty programs, or simply the time and effort required to learn to effectively use a new service or product.
• Intangible assets. Some companies gain an advantage from assets that aren't physical like patents or trademarks. These legal protections make it harder for competitors to offer similar products or services.
• Cost advantage. Companies that have found production efficiencies can either charge more to increase profits or charge less to take market share. Lower-cost production can come from economies of scale, proprietary production processes, superior supply chains, or other factors.
• Network effects. Some businesses become more valuable as more people use them. Social media companies are a prime example. Their value directly increases as more people use their platforms, creating content and connections that bring in even more users in a self-reinforcing feedback loop.
• Technological edge. Companies that develop advanced or specialized technology can gain an advantage that's hard to match without years of research or engineering expertise. Technological advantages need to be maintained through constant innovation, but if done correctly, these companies can stay a step ahead of competitors. Semiconductor companies that have developed difficult-to-replicate AI chips are a perfect example.
• Access to natural resources. Some companies prioritize access to key natural resources, such as rare mineral deposits, oil fields, or water sources. This can provide a sustainable advantage over competitors, particularly when these resources are rare or difficult to purchase.

There are also factors that are mostly outside of companies' control that can contribute to wider moats.

Some companies benefit from regulatory barriers that were put in place or tightened after their businesses were already established. Pharmaceutical companies and utilities, for example, must meet strict requirements before they can sell products or offer services. The cost of surmounting these regulatory barriers can limit new competition from entering these industries.

Other companies gain an inherent advantage from their geographic location. Sometimes companies seek out advantageous locations, but other times, they simply happen to be located in countries or regions that offer unique benefits. For example, strategically located factories can reduce labor or transportation costs, creating more durable moats for their owners.

Broad societal trends and shifts in demographics can also enhance companies' moats. For instance, a company that builds housing for the elderly or offers health care products and services may benefit from an aging population. Similarly, a company that has always prioritized environmentally conscious goods production may gain an advantage as consumer preferences shift toward environmentalism.

Economic moats take many forms, but the widest moats typically derive their strength from several factors. Let's consider a few historical examples.

Waste Management (WM)

Waste Management has built a durable moat mostly through size, scale, and high switching costs. As the largest waste management company in the United States, WM has a dominant market position and benefits from being vertically integrated. It has a vast network of landfills, recycling centers, and transfer stations that give it a cost advantage that's nearly impossible for new entrants in the industry to match.

The company also often secures exclusive municipal licenses to operate waste removal services, providing it with defensive regulatory barriers that impede competition. Perhaps most importantly, Waste Management benefits from high switching costs. It's expensive for local governments and businesses to change waste-service providers. The result is steady cash flow and pricing power in an industry with only a few major rivals.

Costco (COST)

Costco defends its moat through its size, scale, brand strength, and cost advantage. As one of the largest retailers in the United States, one of its key strengths is the ability to negotiate with suppliers for lower prices.

Its membership model also creates a recurring revenue stream and incentivizes customers to shop at the store. This helps the company keep prices low while relying on membership fees for stable earnings. Finally, Costco works hard to earn customer loyalty and trust not only through its low-cost products and focus on customer experience, but also by offering its own popular in-house product line, Kirkland.

Taiwan Semiconductor Manufacturing Co. (TSM)

TSM has mainly used its technological edge, intangible assets, and high switching costs to build a wide moat. As the world's leading contract chipmaker, its business is protected by the large capital spending requirements and years of research and expertise required to match its offerings. The company also holds tens of thousands of patents that protect its proprietary technology and manufacturing processes, giving it a strong base of intangible assets.

The company's dominance in advanced semiconductor manufacturing also creates high switching costs for clients like Apple (AAPL), Amazon (AMZN), and Nvidia (NVDA), which depend on its proprietary manufacturing processes, technology, and ability to produce chips at scale.

Each of these firms demonstrates a different path to a durable competitive advantage. For investors, recognizing these patterns may help identify companies with the resilience to maintain strong returns even as market conditions change and competitors enter the market. 

While companies with wide economic moats are generally expected to have more secure business models and potentially better profit potential, even the widest moats can erode over time.

Sometimes moats erode due to external forces. Government actions like anti-trust lawsuits or new regulations can destroy quasi-monopolies or limit pricing power. Deregulation can do much of the same, inviting new competitors into once-protected industries. Technological innovations can also be disruptive, reshaping markets and making old business models obsolete.

Internal issues can be just as damaging to moats, however. Management error or complacency is often a root cause of moat erosion. When executives make strategic missteps, opting for overly aggressive, debt-driven expansion or ill-timed and poorly executed acquisitions, it can weaken a company's foundations, leading to reduced efficiency and lower profit margins.

Neglecting customer experience or failing to cultivate a culture of innovation can also slowly chip away at a company's moat. Even the most well-respected and highly profitable companies can succumb to a deadly combination of external forces and internal errors.

Consider the example of Pan American World Airways, commonly known as Pan Am. The now-defunct company was once the largest international airline in the United States, dominating the skies between the late 1950s and early 1970s. It had a strong moat at the time, but several factors ultimately led to the company's downfall.

Externally, two major oil crises in the 1970s led fuel prices to spike, increasing costs and weighing on margins. The Airline Deregulation Act of 1978 also eliminated government control over airfares and flight routes, allowing new competition in the industry.

Internal missteps also helped exacerbate Pan Am's downfall. The company had relied on its near-monopoly on international routes before 1978, leaving it without a strong domestic network. Management tried to rectify this issue by merging with National Airlines in 1980, but the merger proved difficult, partly due to National's unionized workforce. Ultimately, by the end of 1991—after another oil price spike caused by the Gulf War—Pan Am had declared bankruptcy.

This example demonstrates that economic moats require constant upkeep. Companies need to reinvest continually in innovation, customer experience, brand strength, and more to maintain their competitive edge. While moats may not last forever, companies that adapt can defend them longer.

Investors looking to identify companies with wide moats should start by gaining an understanding of companies' business models and what sets them apart. Look for durable competitive advantages—like scale, brand strength, cost advantages, or a technological edge—and then attempt to verify those advantages through a company's financial metrics.

For example, companies with robust margins typically have pricing power and cost advantages, while steady revenue growth rates and free cash flows show a firm can reinvest in its business to maintain its moat over time. Companies that have stable earnings and low debt levels also tend to be more prepared to weather economic downturns without losing their competitive advantages. And a high and consistent ROIC is typically a hallmark of companies with wide moats, as it signals management has proven its ability to allocate capital efficiently and profitably.

Investors might also consider other factors beyond financial metrics, like a company's market share, intellectual property, and technological edge, all of which may be difficult for rivals to replicate.

Ultimately, companies with durable moats are structured to survive competition. This means they can potentially offer more predictable returns for investors, which may lead them to outperform in the long run.

For investors who would rather not actively invest or attempt to find companies with durable competitive advantages, there are several exchange-traded funds (ETFs) that seek to invest in baskets of companies with wide moats, offering a passive investing option.

Ultimately, a moat is only as good as a company's ability to maintain it. As markets evolve and competitors innovate, even companies with wide moats can face pressure. Investors who understand how businesses can build and maintain competitive advantages may be able to better identify firms that can grow and survive over the long term.

However, no investment is guaranteed to thrive forever, so it's critical investors consistently research and assess their holdings. Companies with wide moats may be a valuable commodity in the investing community, but every investment comes with risk.