Reviewed by JeFreda R. Brown
What Is an Economic Moat?
Some companies seem to have an uncanny ability to fend off rivals and maintain their market dominance year after year. This phenomenon, known as an “economic moat,” doesn’t just keep rivals at bay but also seems to separate successful firms from those that fail.
Popularized by legendary investor Warren Buffett—it’s perhaps his favorite metaphor, used in dozens of investor talks going back decades—the term “economic moat” draws an evocative parallel with the water-filled trenches that protected medieval castles. In the business world, these moats characterize sustainable competitive advantages that shield a company’s profits from marauding competitors.
But what constitutes an economic moat and, more importantly, how do companies build them? From patents to unbeatable brand recognition, the makeup of these competitive fortifications is far more diverse than their watery antecedents. Understanding economic moats isn’t just academic—it’s a crucial skill for investors seeking companies with the potential for long-term outperformance.
Key Takeaways
- “Economic moat” is a term that refers to a business’s ability to maintain a competitive edge over its competitors.
- The analogy relates to the moats that would surround medieval castles and act as a barrier of protection.
- A company can create an economic moat by taking advantage of its size, intangibles, lower costs, and high switching costs.
- The term economic moat was made popular by legendary investor Warren Buffett.
- Morningstar offers the best-known proprietary metric of companies that have economic moats.
Understanding Economic Moats
An economic moat is more than just a fleeting competitive edge—it’s a sustainable advantage that allows a company to outperform its rivals over an extended period. These can take many forms, but they all serve the same purpose: protecting a company’s market share and profitability from competitive forces. Warren Buffett has explained the idea many times. Here’s one example from when he answers an investor’s question about how he looks for winning companies:
We’re trying to find a business with a wide and long-lasting moat around it, surrounding and protecting a terrific economic castle—with an honest lord in charge of the castle … For one reason or another, it can be because it’s the low-cost producer in some area. It can be because it has a natural franchise [or] because of its service capabilities, its position in the consumer’s mind, [or] because of a technological advantage. For any kind of reason at all, it has this moat around it.
There are many reasons, beyond popular mythology, for Buffett to choose and stick with this metaphor for business success for so long. Historically, moats were built to provide an extra layer of defense against attackers. They made it more difficult for invaders to reach castle walls by adding an obstacle that had to be crossed under fire from defenders.
Contrary to popular myths, moats were not typically filled with dangerous creatures like crocodiles or piranhas—often, the supposed impregnability of a company’s defenses is just as mythic. In many cases, water moats were stagnant water, though some might be filled with debris, refuse, or dead animals. In addition, as gunpowder and cannons became more prevalent in the late medieval period, moats provided less practical defense, and their design changed to reflect new warfare technologies until they disappeared altogether.
While the defensive role was central, moats also symbolized power and prestige. A castle with a large, well-maintained moat reflected the wealth and influence of its owner, particularly during the late medieval period when status displays became increasingly important. This brings us back to Buffett since he argues that it’s in the nature of capitalism that “everybody is going to try” to take on a big castle. But a moat is not enough, he makes clear. Homophonically mixing watery metaphors, he says, “most moats aren’t worth a damn”:
Why is that castle still standing, and what’s going to keep it standing or cause it not to be standing five, 10, 20 years from now? What are the key factors and how permanent are they? How much do they depend on the genius of the lord in the in, in the castle? And then, if we feel good about the moat, then we try to figure out whether, is the lord going to try and take it off for himself—whether he’s likely to do something stupid with the proceeds, etc. But that’s the way we look at businesses.
Our task in the rest of this article is to flesh out the different aspects of what Buffett mentions above since it contains much of what’s been discussed in recent decades in terms of this concept.
Creating an Economic Moat
Let’s start with what Buffett highlights among the typical ways businesses form economic moats:
Cost Leadership
Being a low-cost producer gives a company pricing power and potentially higher margins since the company can either undercut competitors’ prices or maintain higher profit margins. For example, Walmart Inc.’s (WMT) efficient supply chains and economies of scale allow it to offer lower prices than many competitors.
Note
A competitive advantage is essentially any factor that allows a company to provide a good or service that is like those offered by its competitors and outperform them in profits. However, economics holds that, all else being equal, these advantages should disappear over time since every competitor is working day and night at storming and overtaking the castle of the moat metaphor.
Brand Strength
A strong “position in the consumer’s mind” can command premium pricing and customer loyalty. Consumers often choose branded products over generic alternatives, even at a premium price. Consider a company with a strong brand name, like Coca-Cola Co. (KO), whose brand is so powerful that many consumers will choose it over less expensive alternatives worldwide, allowing the company to charge premium prices. This brand loyalty acts as a moat, making it difficult for new entrants to gain a foothold in the market.
Other companies like Apple Inc. (AAPL) and, at least until some missteps in recent years, Nike, Inc. (NKE) have been prime examples of companies with powerful brand moats.
Service That Breeds Loyalty
Some companies build moats through superior customer service. Amazon.com Inc. (AMZN), for instance, has made customer service a cornerstone of its business, creating a reputation for fast shipping and easy returns that keep customers coming back.
Technological Edge
Proprietary technology or patents can create a significant moat. For example, Alphabet Inc.’s (GOOG) search algorithm, continually refined over the years, gives it a technological edge that’s been hard for competitors to match. Switching medieval war metaphors, only the advent of AI in recent years has demonstrated some potential chinks in Google’s armor.
Note
A good example of a competitive advantage would be a low-cost advantage, such as cheap access to raw materials.
Intangible Assets
Buffet leaves wide open how different companies might fortify their businesses. Many do so with intangible assets like patents, trademarks, and regulatory licenses. Pharmaceutical companies, for instance, rely heavily on patent protection to maintain their competitive advantage.
The patent acts as a legal moat, preventing competitors from producing the same drug for a set period. This exclusivity allows the company to recoup its research and development costs and generate substantial profits before generic alternatives can enter the market.
Benefitting From the Size of the Castle
Being big can sometimes, in itself, create an economic moat for a company. At a certain size, a firm achieves economies of scale. This is when more units of a good or service can be produced on a larger scale with lower input costs. This reduces overhead costs in financing, advertising, production, etc.
Large companies that compete in a given industry tend to dominate the core market share of that industry, while smaller players are forced to either leave the industry or occupy smaller “niche” roles.
Switching Costs
Being the big fish in the pond has other advantages. When a company can establish itself in an industry, suppliers and customers can be subject to high switching costs should they choose to do business with a new competitor.
As such, a rival doesn’t have to make a cheaper widget; they have to make a widget that’s cheaper than their competitor’s plus the cost of switching, all while making it worthwhile in time and effort.
The Durability of Economic Moats
However, Buffett emphasizes that having a moat isn’t enough. The moat’s durability is crucial. He mentions the following:
- Longevity: Will the advantage last for five, 10, or 20 years?
- Key factors: What are the critical elements maintaining the moat?
- Permanence: How stable are these factors?
- Management dependence: Does the moat rely too heavily on current leadership?
- Management integrity: Will company leaders exploit the moat for personal gain or make poor decisions?
It’s not just about identifying a company’s current strengths but predicting how they will hold up against competitive pressures and changing market conditions.
Note
Perhaps the most durable “moat” is the network effects of one’s products. This occurs when a product becomes even more needed by others as it gains popularity. Social media platforms are classic examples of this. Once these network effects take hold, competitors can’t just launch a better product or service to get ahead.
The Role of Management
While a strong economic moat provides a company with competitive advantages, the effectiveness of that moat largely depends on the quality of the company’s management, as Buffett makes clear. Even the widest moat can be squandered by poor leadership decisions. Conversely, exceptional management can reinforce and expand existing moats, or even create new ones.
These are the names for management styles that can have varying impacts on a company’s economic moat:
Visionary leadership: Some leaders are known for their ability to anticipate future trends and position their companies accordingly. This approach can help create and maintain technological or brand-based moats.
Operational excellence: CEOs and management teams that build their companies’ moats through relentless focus on operational efficiency and cost management.
Customer-centric management: Leaders who prioritize customer satisfaction can create strong service-based moats.
Innovation-focused leadership: Often confused with visionary leadership, this is the term for management teams that emphasize continuous progress in their products that can be sustained over the long term.
Financial Stewardship: Managers who allocate capital wisely, reinvesting in the business rather than pursuing short-term gains, can strengthen a company’s competitive position over time.
Ultimately, the quality of management can be the difference between a company that leverages its economic moat for sustained success and one that sees its competitive advantages slowly erode.
However, suppose you develop and patent a juicing technology that allows you to get 30% more juice out of the average lemon. This would have the same effect of reducing your average cost per glass of lemonade.
This time, your competitors will have no way of duplicating your methods, as your competitive advantage is protected by your patent. In this example, your economic moat is the patent that you hold on your proprietary technology. In this case, if your lemonade company was a public firm, your stock would probably outperform that of your competition in the long run.
Note
Markets evolve, technologies change, and consumer preferences shift—after all, no one builds actual moats anymore. The challenge for companies is not just to build a moat, but to continually widen and deepen it to maintain their competitive position.
How To Identify Companies With Economic Moats
Determining which firms have the strongest economic moats is vital for investors seeking long-term value. While qualitative analysis is essential, several quantitative metrics can help you spot those with protective moats. Here are the different kinds of metrics analysts typically review:
Measures of Profitability
High return on invested capital (ROIC): Companies with wide economic moats tend to consistently generate high ROIC. This metric helps assess how efficiently a company uses its capital to generate profits. A consistently high ROIC (typically above 15%) over five to 10 years suggests a sustainable competitive advantage.
Gross and operating margins: A company with a moat can usually charge premium prices or achieve cost efficiencies, leading to higher gross and operating margins.
Cost advantages: Companies with moats often achieve cost advantages through scale, production efficiency, or access to unique resources. Cost advantages enable companies to underprice competitors or maintain healthy margins, even in competitive markets.
Measures of Stability and Growth
Revenue growth and market share: Companies with economic moats often dominate their industries or niches. Examining market share and revenue growth over time helps indicate whether a company can fend off competitors and sustain its position.
Earnings stability: Less volatile earnings compared with peers suggest a more defensible market position.
Free cash flow: Strong and consistent free cash flow generation can indicate a company’s ability to reinvest in its moat.
Low debt-to-equity ratio: Companies with strong moats often don’t need to rely heavily on debt financing.
Measures of the Ability To Hold Market Share
Market leadership: Most clearly, being No. 1 or 2 in an industry can be a sign of a powerful competitive position.
Patents, trademarks, and proprietary technology: Intellectual property or proprietary technology is a clear sign of a moat, especially in industries that rely on innovation. A company’s ability to continually develop and protect such assets gives it a significant edge over competitors.
Brand strength: A powerful brand can create a durable moat by establishing loyalty and trust with consumers. Measuring brand equity, customer satisfaction, and the company’s share of mind in the marketplace can provide insights into its moat.
Real-World Example: Nvidia’s Economic Moat
NVIDIA Corp. (NVDA) is a compelling example of a contemporary company that has built a significant economic moat, especially in recent years. As a leader in the graphics processing unit (GPU) market, Nvidia has solidified its position through a combination of technological advances, brand strength, and strategic partnerships.
Technological Leadership
Nvidia’s moat is primarily built on its ability to continuously innovate and dominate in key markets such as gaming, AI, and data centers. Its GPUs, particularly in the AI and machine learning space, are, for now, leading the industry. Nvidia’s proprietary technologies, such as its CUDA platform for parallel computing, give it a significant edge over competitors. These not only provide Nvidia with its technical lead but also lock in customers who are heavily dependent on its specialized software and hardware.
Strong Network Effects
Nvidia benefits from network effects in industries that rely on GPU technology, such as gaming and AI research. Developers optimize their software for Nvidia’s hardware, making it difficult for users to switch to other platforms without facing performance trade-offs. This strong ecosystem of hardware and software compatibility deepens the moat by fostering loyalty and reducing the incentives for customers to switch to rival products.
Partnerships and Market Penetration
Nvidia’s strategic partnerships with major tech companies, including its growing role in cloud computing and its alliances with major automakers for self-driving cars, reinforce its moat. These partnerships ensure Nvidia’s products are a key player in several fast-growing sectors.
High Margins and ROIC
Nvidia consistently posts impressive gross margins, regularly exceeding 60%, a sign of its ability to charge premium prices for its products. Its high ROIC, supported by scale and strong market demand, indicates that Nvidia’s competitive advantages could be sustainable over the long term.
The Contrarian Take on NVDA’s Moat
While NVDA’s rapid ascent in market share this decade has made many analysts converts about its prospects, there are reasons to hold back from believing that NVDA has created a sustainable moat around its operations. While Nvidia dominates the GPU market, the tech industry evolves rapidly, and competitors like Advanced Micro Devices Inc. (AMD) or Intel Corporation (INTC) could erode Nvidia’s market share through aggressive pricing or technological breakthroughs.
The reliance on its GPU gains means Nvidia’s moat could narrow if a rival develops superior AI or gaming chips, or if emerging technologies like quantum computing render GPU architectures less relevant. In addition, a contrarian might highlight Nvidia’s dependence on strategic partnerships and question whether shifting industry alliances or supply chain disruptions could weaken its dominance over time. In their view, Nvidia’s moat is more vulnerable to disruption than the market assumes.
Investing With Moats
VanEck Morningstar Wide Moat ETF
In addition, a contrarian might note that those who have to put their money where their mouth is, namely those managing VanEck Morningstar Wide Moat ETF (MOAT), haven’t made it among their top 10 holdings. Thus, beyond doing your own analysis, one way to see where one major firm is placing its bets on the “moat”-ness of certain companies is by following the progress of the MOAT exchange-traded fund (ETF). Here are its major sector and company holdings, along with key trading details.
Morningstar’s Economic Moat Ratings
The MOAT ETF is based on a proprietary system from Morningstar, the investment research firm. This system, its economic moat rating, is a well-known metric among investors interested in finding and investing in moats.
Morningstar says it classifies companies into three categories:
- Wide moat: Companies expected to maintain competitive advantages for over 20 years.
- Narrow moat: Companies likely to sustain advantages for 10 to 20 years.
- No moat: Companies without significant advantages or advantages expected to dissipate quickly.
Morningstar says it uses these factors when collating its moat ratings:
- Historical financial performance: Companies consistently generating returns on capital above their cost of capital often indicate the presence of a moat.
- Future sustainability: Analysts assess whether past performance is likely to continue, considering industry trends and company-specific factors.
- Sources of competitive advantage: Morningstar identifies five primary sources of economic moats, including network effects, intangible assets, cost advantages, switching costs, and its efficiency in serving its market over competitors.
While worthwhile, investors should be aware that moat ratings are based on analysts’ judgments and may not always accurately predict a company’s future performance. Market conditions, technological disruptions, and management decisions can all impact a company’s competitive position over time.
Comparing MOAT With a Benchmark, SPY
While much further analysis would be needed, a starting point for determining the gains from investing in the MOAT ETF would be comparing its price shifts with a benchmark. In this case, we chose the SPDR S&P 500 Index ETF (SPY), a common choice for these types of ETFs (and indeed, MOAT’s own in some of its quarterly updates). We took SPY’s price action and calculated what would have happened if an investor had taken the same amount of MOAT’s IPO price, $19.79, and invested it in SPY instead.
The two charts below give a visual means of seeing how they have compared since MOAT’s IPO. MOAT, it turns out, tracks SPY’s price action pretty well, coming out a bit ahead. However, those investing passively in SPY might think the sustained effort to identify moats hasn’t led the actively managed MOAT to vanquish its benchmark in some medieval fashion, as one might expect with an expense ratio (0.46%) five times as much as that of SPY (0.09%).
Who Is Warren Buffett?
Warren Buffett is often considered one of the most successful investors in history and is widely regarded as the “Oracle of Omaha.” Born in 1930, Buffett is the CEO of Berkshire Hathaway Inc. (BRK.A), a conglomerate that owns a diverse array of businesses and holds significant stakes in many well-known companies. Buffett is famous for his value investing strategy, his frugal lifestyle despite his immense wealth, and his pledge to give away the majority of his fortune to philanthropic causes.
What Is Value Investing?
Value investing is an investment strategy that involves buying securities that appear underpriced by some form of fundamental analysis. The concept was developed by Benjamin Graham and David Dodd, who taught at Columbia Business School in the 1920s. Value investors look for companies with strong fundamentals that are trading at a discount to their intrinsic value. This could be due to short-term market pessimism, temporary business challenges, or simply because the company isn’t “exciting” enough to attract investor attention.
What Are Other Common Metaphors Used in Investing and Finance?
Like a good teacher, finance professionals often use metaphors to explain complex concepts. That said, technical analysts (e.g., “dead cat bounce“) seem to have the most viscerally memorable. Other common examples include the following:
- “Bull” and “Bear” markets: Representing optimistic (rising) and pessimistic (falling) market conditions.
- “Rocket ship“: Describing a stock that’s rising very quickly.
- “Underwater“: Referring to an investment worth less than its purchase price.
- “Headwinds” and “Tailwinds”: Factors that make growth harder or easier, respectively.
- “Unicorn”: A start-up valued at over $1 billion.
Can You Tell Me About Those Technical Analyst Metaphors?
Yes, it’s quite a list, suggesting a field rife with dark humor—not a bad thing to have around when trades swing the wrong way. In no particular order, these are real names for events, strategies, and market moves you’ll find in any technical analyst‘s lexicon, limiting ourselves to the first 10 that spring to mind.
- Dead cat bounce: Let’s at least define this for you since we mentioned it above. It’s a temporary recovery in stock prices after a huge fall—from the fact that even a dead cat will bounce if it falls far enough.
- Catching a falling knife: This warns against buying into a market that’s dropping rapidly. Just as grabbing a falling knife is dangerous—this doubles as good kitchen advice—so is trying to time the bottom of a crashing market.
- Blood in the streets: Originating from Baron Rothschild, this phrase suggests the best time to buy is when there’s extreme pessimism in the market; this is a contrarian’s take on the mar traps: These terms describe situations where the market gives a false signal that a reversal is occurring. A bull trap tricks investors into thinking a downtrend has ended when it’s actually just a temporary upward movement before further declines. A bear trap does the opposite.
- Capitulation: Technical traders don’t just “throw in the towel”; they capitulate. The word evokes abject and humiliating surrender in war.
- Bagholders: This sounds innocuous—it’s used for investors left holding worthless stocks—but it derives from those left holding an empty bag after a robbery.
- Sheep getting slaughtered: Refers to naive investors following the herd into bad investments.
- Dead cross: There’s no shortage of “dead” things in trading. This is when the short-term moving average crosses below a long-term moving average, often seen as a bearish signal. More positively, the golden cross is a bullish signal.
- Gravestone doji: A candlestick pattern shaped like a gravestone, indicating a bearish reversal.
- Hanging man: Yet another candlestick pattern, shaped like a hanged man, suggesting a potential price drop coming.
What Is Apple’s Economic Moat?
Apple has a few economic moats, the primary one being creating products that didn’t exist before, such as the iPod, the iPhone, and the iPad. After creating these products, Apple’s economic moat has consisted of its marketing, its design, and its user-friendly interface.
What Company Is Considered to Have the Widest Economic Moat of All Time?
While it’s challenging to definitively claim any single company has the broadest economic moat of all time, many experts would point to Coca-Cola as a pretty good example of a vast and enduring moat. Warren Buffett himself has frequently praised Coca-Cola’s moat, and Berkshire Hathaway has been a long-term major shareholder.
The Bottom Line
Warren Buffett’s castle-and-moat metaphor is often used to illustrate how companies protect their profits from competitors. While moats can take various forms—from cost advantages to brand power to network effects—their true value lies in their durability.
For investors, identifying companies with wide, enduring moats can be key to long-term investment success. However, no moat is impregnable forever. Market conditions change, new technologies emerge, and consumer preferences shift. Thus, successful investing isn’t just about finding companies with moats today, but anticipating how those moats might evolve or erode over time.