Economic Moats

Bodiam Castle
Bodiam Castle in East Sussex, England. Attribution:

Warren Buffett coined the term economic moat when talking about a company’s ability to maintain its competitive advantage against competitors over long periods of time. In an interview with NDTV, he described outstanding businesses as those  which increase their moat year over year rather than focus so much on quarterly earnings. In the interview, he called these businesses economic castles. In any capitalist society, whenever you have an economic castle, there will be others who will try to take it away from you (i.e. generate those high returns you earn on your capital on their own capital). He therefore views management as knights, or guardians of the moat – who worry about protecting the castle and widening the moat over time or making it more difficult to cross, by tossing in sharks, piranha’s, even octopi (e.g. service, product design, consumer associations to the product/service).

Sustainable economic moats are an essential consideration for any serious investor.

In a recent guest post on John Huber’s Base Hit Investing, Connor Leonard expands on this concept, talking about Legacy Moats – large economic moats found in businesses that have high returns on capital but lower returns on incremental capital (i.e. they’re great businesses with a strong returns on capital sans compelling opportunities to deploy incremental capital at similar rates) vs Reinvestment Moats – that earn strong returns on capital and have opportunities to deploy that incremental capital at high rates, with a long runway ahead of them (i.e. the competitive advantage will continue and even strengthen over time). It’s an excellent guest post that I highly recommend! You can read it here.