2 Types of Economic Moats That Companies Can Have

The term “economic moat”, which was popularised by Warren Buffett, takes its roots from the deep, water-filled moats that surround a castle that was designed to protect against invaders. Similar to these traditional moats, companies that have “economic moats” have competitive advantages that protect them from competition.

There are a few ways that a company can develop economic moats in their business. In this article, I will take a look at two types of economic moats.

Low-cost advantage

Businesses that can keep their cost of production low can, in turn, sell their products at much lower rates than their competitors. All else being equal, consumers are much more likely to engage the services of companies that are cheaper.

Good examples of businesses that have a low-cost advantage are rubber glove makers in Malaysia. Malaysia and Thailand are two of the largest producers of rubber in the world. Rubber glove makers that operate in this region have easier access to rubber and can minimise the cost of production. It is, therefore, no surprise to see many of the largest rubber glove makers operating in this region. Competitors are unable to compete with them, given the commodity-like nature of rubber gloves.

The low-cost advantage may be one of the oldest tricks in the books, but can still provide businesses with a deep economic moat that is difficult to erode.

Network effect

A network effect is one whereby a sheer number of users or participants of a service increase the value of that service.

Perhaps the first business that comes to mind is the social media business. One of the biggest reasons why big social media companies are difficult to replace is the sheer number of people in the system. As more people join the network, they, in turn, attract more people along and grow the network, increasing the value of the platform to others.

Marketplaces also enjoy the network effect. E-commerce sites that have a large database of merchants and customers inevitably attract each other onto the platforms and further fuel growth.

Competitors will face difficulty breaking into the near-monopolistic hold of the businesses.

The network effect, therefore, is one of the best and most secure economic moats that a company can create. However, it is also one of the most difficult moats to achieve. Only a handful companies in the world can boast such an advantage.

The Foolish bottom line

As investors, we should not undervalue the advantage of an economic moat. Economic moats can keep a company thriving in the long-term and help to expand its business in the future, even in harsh economic conditions.

Stay tuned for more on economic moats in the upcoming days!

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.