The ‘Economic Moat’: What It Is and How to Build It
No matter how niche your product or service, at some point in the future you’ll inevitably be competing to maintain a sizable market share, retain customers, and protect your profits.
When you’re running a UAE-based company offering a unique product or service in a highly competitive market, how can you protect your offering and ward off the competition?
The answer is mediaeval: build a moat. Like the defence around a stronghold, an economic moat can help deter your competitors and keep your business safe from financial harm.
Here’s everything you need to know about economic moats, and some ideas for how you can build one.
What Is an Economic Moat?
An economic moat is a term used to describe a company’s ability to protect its competitive advantage and market share from rivals.
Generally speaking, a moat is something that is difficult for competitors to imitate or replicate. For that reason, it helps to sustainably maintain a business’s performative edge, protects its profits, and piques the interest of investors over an extended period of time.
Put simply, an economic moat gives a company, which is offering a similar product or service to its competitors, an advantage that enables it to outperform rival companies.
The term, popularised by legendary investor Warren Buffett, is derived from the popular defence system deployed around mediaeval castles – a deep ditch, usually filled with water, which made it more difficult to attack.
Why Build an Economic Moat for Your Business?
Building an economic moat for your business is a way of using a unique differentiator to ensure long-term sustainability and profitability, and shield your market share from competitors. Why is it important? A general principle of economics is that no matter how unique your offer, over time competitors will make up ground, using similar or better tactics to seize the advantage.
Take this recent example. In the first quarter of 2022, the world’s largest streaming giant, Netflix, announced a drop of around 200,000 subscribers, and a loss of around 40% of its market value.
In recent years, the streaming market has reached saturation point in key territories like the US and Canada. Netflix is also facing increased competition from rival media groups such as Disney+ which, as well as replicating the subscription-based model and production of original content, has its own roster of big-name media franchises and brands.
It could be argued that, in terms of its model, Netflix missed out on an economic moat. It might be a streaming innovator and market leader, but it has yet to identify a wide economic moat that sustainably safeguards its position for the future. That’s because economic moats can be tricky to pin down; they take many forms and leverage different advantages.
Benefits of Economic Moat
An economic moat is a desirable competitive advantage that allows a company to be successful in the long run.
- Companies with an economic moat are more likely to outlast their competition and preserve market dominance in order to thrive.
- It helps a business in maintaining desired profitability even in times of depression. As a result, in the event of a depression, when many businesses are compelled to close their doors, businesses with an economic moat are more likely to survive.
- Because the company’s goods and services have a growing value among competitors, they maintain the market share and make customers choose their products.
- As a means of “locking in” customers, companies create high switching costs. This means that it is difficult for customers to switch to a competitor, enabling the company to increase prices year after year to achieve hefty profits.
- An economic moat can be used to charge premium prices for competitive goods and services.
- Competitive advantage is often attributed to cost-effectiveness, that is, to lower prices for goods and services compared to competitors. In this way, it eventually helps reduce various unnecessary and avoidable costs.
Wide Moats Versus Narrow Moats
A wide economic moat creates a high barrier to entry for competitors because it is difficult to duplicate. For this reason, a business with a wide moat is likely to have a large market share or a patented product which is intrinsic to their offering, such as Coca-cola’s unique recipe, or, in the case of Google, their trade-secret algorithm for indexing and searching web pages.
On the other hand, a narrow economic moat gives a company a minor competitive advantage. Typically, this occurs in highly competitive industries with lower barriers to entry and limited protection over intellectual property. A narrow economic moat will give a business the edge for a limited period of time. This is because new competitors are regularly popping up, and there is little scope to protect intellectual property rights.
Ways to Make an Economic Moat
Like the mediaeval defences that inspired them, economic moats can be different shapes and sizes. Whilst it’s possible for a company to stumble across its economic moat retrospectively, many well-known types of moat are premeditated attempts to protect market share and ward off the competition.
Taking different forms, cost moats are a common and robust defence against competitors.
For example, large retailers are able to leverage economies of scale to offer lower prices than their competitors. If they can drive down costs in the supply chain whilst increasing growth, they create a competitive advantage.
Sunk costs are another way of building an economic moat for your product or service. If the customer has already made a sizable investment with you, they may be reluctant to look elsewhere (and incur further costs).
In recent years, the subscription model provides the same sort of lock-in with the opposite rationale. By offering a product or service on a subscription basis, it’s easy to present the freedom of choice. The customer can leave at any time.
However, when a recurring monthly fee is nominal – take Apple’s iCloud plans as an example – customers are less likely to think about cancelling their subscription. Doing so would create inconvenience, like having to relocate multiple files to a different cloud storage provider.
Potential inconvenience and additional costs cause many people to stick with the same trusted product or service when they think about switching. By baking in trust and reliability to their customer relationships, some businesses are able to build a moat by deterring consumers from switching – even though their offering might actually cost more.
When your company’s resources are unique, they can become a valuable tool for creating your moat:
- Regulatory moats cultivate regulatory relationships which can be hard for competitors to break down.
- Intellectual property (IP) which cannot be duplicated by competitors can be a lucrative advantage for businesses. This is especially common in healthcare, where pharmaceutical companies obtain the patent on a particular drug.
- Knowledge is another way of creating a moat, although it’s potentially difficult to defend in the long term. This kind of moat is common in technology companies with unique knowledge around a particular product or service.
Luxury brands are able to charge premium prices for products or services, which are similar to their competitors, because they’ve cultivated a distinct culture and value proposition – sometimes something quite intangible, which has turned them into a status symbol which attracts repeat customers. You only have to compare the latest smartphone price points for Apple and Samsung to see the power of culture on people’s brand perceptions, and their willingness to pay more.
Products culturally ingrained into society can also develop a secure economic moat. For example, although Dyson may be the most popular brand of vacuum cleaner in the UK with 12 million users in 2020, the brand name ‘Hoover’ is still commonly used to describe the act of vacuum cleaning. Hoover may have slipped down the rankings in that particular market, but it still has a secure foothold, even though its moat has been breached by Dyson. Meanwhile, its usurper’s moat is reinforced by multiple patented technological advances.
When a product or service has a network effect, its economic moat is strengthened because its value grows in correlation to the number of users. Social media networks are an obvious example of network moats. When it comes to network moats, technology provides three main opportunities: data, platforms, and marketplaces.
Data is the new currency, so when companies utilise relevant and available data, they’re able to gain a clear data-driven advantage over the competition. Google’s data moat ensures it continues to hold around 86% of the search engine market – a share 12 times larger than its nearest rival.
Platforms, such as Facebook, build their moats by sustaining user engagement with new features and releases, adding value to their existing offering and making it increasingly inconvenient to switch to a different ecosystem.
Similarly, online marketplaces – where suppliers and customers are brought together – create a moat by adding more and more suppliers to their ecosystem. This creates healthy competition and ultimately creates better value for consumers. In turn, lower prices attract more customers and therefore drive growth.
The Right Moat for Your Business
Some economic moats are only viable for giant organisations, which can take advantage of economies of scale. Others rely on intellectual property laws to keep the competition from catching up. For some businesses, their moat only comes into focus when they’ve been on the market a while.
Whatever moat works for your business, the bottom line is that building a business moat is a powerful way to protect your enterprise, both now and in the future.
FAQ 1: What do you mean by Economic Moat?
Business owners and managers use the term “economic moat” to refer to their ability to maintain competitive advantages and market share over their competitors over a long period of time.
FAQ 2: What are the types of Economic Moat?
There are four main types of economic moats:
- Low-Cost Producer – A company that is able to deliver its product or service at a low cost is likely to have an edge over its competitors because they can undercut their prices as a result of economies of scale.
- High Switching Costs – When a customer switches over from one product to another, they incur one-time expenses. For you to consider switching again, you’d need a really good reason, such as a package deal on an account and mortgage.
- The Network Effect – Network effects are among the most powerful competitive advantages, and they are also the easiest to recognize. More people using a good or service increases the value of the good or service both for new and existing users.
- Intangible Assets – It is possible for some companies to gain an advantage over their competitors because they have nonphysical assets, or “intangible assets.” Among the intangibles are intellectual property rights, government approvals, brand names, unique company cultures, and geographic advantages.
FAQ 3: How do you identify Economic Moats?
A strong economic moat enhances the chances of companies thriving on the stock market and producing significant cash flows over time. Most customers immediately choose these companies because they have products/services that are obvious and best for them. Ultimately, a company with a strong economic moat should be attracting customers from competitors, which should be reflected in its financial performance.
FAQ 4: Why are Economic Moats advantageous?
A company’s economic moat is its competitive advantage over its rivals due to deeply embedded benefits such as intellectual property, a lower cost of capital, a network effect, or brand recognition. As competitors struggle to cross the metaphorical economic moat, this combination of tangible and intangible assets strengthens a company’s market share for years or even decades.