Fundamental Analysis · Intermediate · 5 min
Moats: spotting competitive advantages
You can name the five common sources of a competitive advantage and check in the numbers whether a company's high returns have lasted.
Profits under attack
When a business earns unusually high profits, others notice. Competitors copy the product, undercut the price or poach the customers. In most industries, that slowly pushes profits back to normal.
Some companies keep earning high returns for decades anyway. Investors call what protects them a moat, after the water ditch around a castle. Understanding moats helps explain why some companies deserve higher valuations than others, and why many that look strong today do not stay that way.
Five sources of a moat
An economic moat is a lasting advantage that lets a company keep returns above its cost of capital despite competition. The term is closely associated with Warren Buffett. In his 2007 letter to shareholders, he wrote that a truly great business needs an enduring moat that protects excellent returns on invested capital.
The research firm Morningstar, which rates companies on their moats, groups them into five sources:
- Intangible assets: brands customers pay more for, patents, or licenses that keep rivals out.
- Switching costs: when changing to a competitor is expensive, slow or risky, for example a company's accounting software.
- Network effect: a product becomes more valuable the more people use it, such as a marketplace with many buyers and sellers.
- Cost advantage: producing more cheaply than rivals, through scale, location or processes.
- Efficient scale: a market only large enough for one or a few companies, such as a pipeline or an airport, where a new entrant would leave everyone unprofitable.
Moats are not permanent. Technology, regulation and changing habits can drain them. Buffett avoided industries prone to rapid change for that reason.
Returns that last
Stories about moats are easy to tell. The numbers are the test. The key figure is return on invested capital (ROIC): operating profit after tax divided by the capital tied up in the business. A moat shows up as an ROIC that stays well above the cost of capital, year after year.
Two fictional companies both earn 18% in year 1, against a cost of capital of 8%:
- Company A still earns 17% in year 10. Competitors tried, but customers stayed.
- Company B falls to 7%, below its cost of capital. Its high returns attracted rivals, and nothing stopped them.
In year 1, both looked equally strong. Only the long history told them apart. Check margins and returns over ten years, through at least one recession, before calling anything a moat.
Common mistakes
- Confusing fame with a moat. A well-known brand is no protection if customers switch for a small discount.
- Judging from one good year. Cyclical peaks make many companies look protected.
- Assuming a moat lasts forever. Technology and regulation can make yesterday's advantage worthless.
- Ignoring the price. A company with a wide moat can still be priced so high that its future returns for investors are poor.
The takeaway
A moat lets a company earn high returns for many years despite competition. You see it in returns on capital that stay high, not in one good year.
Check yourself
Quick quiz
4 questions. Instant feedback, nothing is saved.
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1Tap the bar that suggests a lasting competitive advantage.
Tap the chart.
Company A still earns 17% after ten years, well above its 8% cost of capital. Competition has not eroded its returns.
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2A messaging app becomes more useful the more people use it. Which moat source is that?
Each new user adds value for the others, which makes it hard for a rival to start from zero.
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3Why does a single year of high profit not prove a moat?
In a normal market, competition pushes high returns down over time. A moat is what stops that.
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4What did Warren Buffett write about moats in his 2007 letter?
He looked for enduring advantages and avoided industries prone to rapid change.
of 4 correct.