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Economic moat

Economic moat is a term popularized by Warren Buffett describing a company's competitive advantage. In the chemical industry these are often called barriers to entry. They help defend against competitors who inevitably will try to copy successful products.

Expanded Definition

The wider and more durable a company's competitive advantages, the wider the moat. And the wider the moat, the better for a company, as it keeps competitors at bay and profits high. Facets of a moat can include:

Economies of scale

Economies of scale are cost-based in nature. The more volume a business cranks through, the more units with which it can spread over its fixed costs. Lower per-unit cost structures allow the producer to either earn higher profits than competitors or muscle them with lower prices. Well known examples of companies with scale-based advantages include Wal-Mart and Google.

That would include the ability to build a larger or world scale plant and sometimes the ability to manufacture a key intermediate and use all of the plant's output. Key raw materials can be secured under long term contracts as in the case of orphaned natural gas by agreeing to develop a field, drill wells and build pipelines, or to develop a minesite, or take-or-pay contracts to take all of a plant's output.

Factor in market share. When an industry leader like Inbev Anheuser-Busch with 45% of the US beer market competes with a Pabst, with 2% market share, they can go toe to toe on every aspect. Advertizing, marketing, sports sponsorship, manufacturing, distribution, purchasing materials, and on and on. The small competitor has to be clever to survive and prosper. Usually that means finding a niche and exploiting it nimbly. Often the niche is small or insignificant to the major competitor. Some are regional; some highly specialized for a select group of customers.

Intellectual property

Intellectual property such as patents, trade secrets, trademarks, brands, or human capital can give a company an edge over rivals. Not all intellectual property is equally valuable to a company, though. Human capital, for example, can walk right out the door to join a competitor or start a firm of its own. And while they can prove surprisingly durable (think Coca-Cola), brands require reinvestment aren't in and of themselves money makers. Patents, though, have defined lives that provide exclusivity to the patent owners' technology, which has been a boon for the likes of pharmaceutical companies. Hence, critical formulations like those of Coca-Cola are protected as trade secrets. Products are made from syrup concentrates, but few know their ingredients.

Technology also includes the know-how to handle difficult materials (toxic, corrosive, explosive, extremely hot or cold, etc) or to create ultra high quality or special properties.

Relationships

Many companies have long standing relationships with key suppliers. General Motors and Dupont are closely related in that Dupont was an early investor in GM and PS Dupont was an officer at GM in a critical era. Dupont was a major GM stockholder until the '60s. Hershey Foods was for years the supplier of a key ingredient of Coca-Cola. Some suppliers build plants to serve a single customer or even on the customer's site.

Network effect

Switching costs

Examples

Hostess The recent bankruptcy/liquidation of Hostess, baker of Wonder Bread, Hostess Cupcakes, Twinkies, and other baked products is instructive. Every commercial baker has dough mixers and baking ovens. Any one with idle capacity can make these products. Barriers to entry are low. Hence, the business depends on distribution channels, shelf space, product positioning, market share, and especially loyalty to the brand names. For products with limited shelf life, a network of day old stores that allows sale of outdated products at some value could be a major contributor to profitability.

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