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Wednesday, February 15, 2012

What is an Economic Moat?

Students of medieval history know that castles had moats surrounding them to protect against invaders.  The moat was just a big ditch filled with water.  With the moat, all the castle's lord needed was a good drawbridge that would hold his horses, a sober lookout, and a couple of working catapults.  At the cry of "invaders me lord," the drawbridge would come up, the catapults loaded, and a real life game of "Dragons and Dungeons" would be on.

Thinking about it, I guess some good torture devices in a good dungeon would also be necessary to chain the captured invaders who stupidly fell into the moat.  If you could get Billy Crystal to do the torturing, all the better.  But I'm in the weeds - the basic idea of the castle moat is pretty straightforward.

This concept was adapted by Warren Buffett to describe companies that have some built-in protection mechanism that ward off the essence of what makes the economy go - competition.  He called it an "economic moat."  Anyone with a sense of economics understands that, if we get an idea, implement it, and start making the big bucks, competitors will swiftly arrive and compete our profits away.  Ask the Beanie Baby crowd.

Investors want to avoid companies whose profits can be competed away.  Instead, the investor is a lookout (similar to that in the medieval castle) seeking profitable companies with significant barriers to entry - i.e. an economic moat.  The example that comes immediately to mind are the patents enjoyed, for example, by drug companies.  Another example would be Apple's products and brand - unless, of course, you're in China.  Then you can copy the product, copy the logo, and try to cross the moat.

The desire to explain Buffett's valuable concept came to me yesterday as I read Dividend Monk's blog on "12 Dividend Companies with Large Patent Shields."  This article is actually the 3rd in a series that examines different ways companies gain the advantage of an economic moat.  The series makes great reading for the DIY investor.

1 comment:

  1. Technology advancements are filling in economic moats all the time. Newspapers and TV stations and TV networks are a prime examples. Moats can be illusory and often have limited life-spans.