Identifying Competitive Advantages (Moats) in Finance
The secret to success in investing under the dynamic world of finance is that identifying businesses, which will continue to perform extraordinarily well and have sustainable competitive advantages. These kinds of advantages are also referred to as "economic moats" as they can effectively insulate the companies from any competitor and subsequently sustain long term profitability. A moat in the investment context refers to a competitive advantage that a firm has over its competition, and as such, stays at the top of its industry or sector. Understanding these advantages is crucial to both value investors and growth investors because they highly contribute to the ability of the company to create returns over time.
The concept of an economic moat will be described along with the several kinds of moats, followed by how one would analyze the industry and sector dynamics, using examples of how actual companies set up strong competitive advantages.
What is an Economic Moat?
Legendary investor Warren Buffett and Chairman of Berkshire Hathaway described what he termed an "economic moat" – in other words, the competitive edge that prevents threats from the invasion of competition forces. The moat surrounding a castle is just such an impenetrable fortress to the enemy; on the other hand, a robust economic moat forms around the business. It's what makes the entity more likely to sustain profitability in the long term with returns.
Normally, a business that has a wider economic moat usually produces more return on capital and sustainable growth, while a business without will be more easily affected by changes in the market and competitive pressure. It is in this light that the moats are relevant to investors that would like to focus on firms with lasting values as opposed to those that are potentially susceptible to dramatic decline.
Moats of types
Economic moats can be structured in different ways depending on the type of bu