Economic Moat

We've heard this term, many times over now. Warren Buffett and his fellow value investors swear by it ... the economic moat finds it's place on page 1 of value investing 101.

Pat Dorsey in his book, The Little Book That Builds Wealth, defines the moat as anything that protects a company's profits from competition and allows the company to earn exceptional returns on capital over long periods of time.

1. Intangibles
Examples of this are a strong brand that allows a business to charge more for comparable items, patent protection on products like drug formulations and technologies, and regulatory licenses that are particularly hard to obtain.

2. High switching costs
This represents the "sticky" customer advantage shared by banks and widely adopted software vendors. Who wants to go through the hassle of transferring an account or training an entire staff on a new piece of software?

3. Network effects
A network effect occurs where the value of a business increases with each node on the network. (refer to my previous post on "Cumulative Advantage"). Dorsey talks about the credit card processors, Mastercard. As more people use it, more new places sprout up that want to accept it; and hence even more people start using it. Another example is eBay - sellers go there because that is where the buyers are, and buyers go there because, you guessed it, that's where the sellers are!

4. Cost advantages
a) Have a better business model like Dell or Southwest Airlines, where the business structures allow you to underprice the competition.
b) Have a better location like having a iron ore mine next to the steel plant reduces transportation and handling cost.