Economic Moats: Narrow and Wide

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Economic Moats: Narrow and Wide

There are certainly gradations of moat width, and companies with milder competitive advantages have "narrow" moats. Far more companies have narrow moats than wide ones. Narrow-moat firms are, on average, of a much higher quality than no-moat companies. Generally, narrow-moat companies generate lower returns on invested capital than wide-moat companies but still have returns slightly above their cost of capital. Narrow-moat companies typically come in two varieties:

Narrow moat variety 1: firms with eroding moats

These companies have competitive advantages, but they are eroding due to a shifting industry landscape. This scenario is faced by some of the consumer-products companies. The pricing power they once enjoyed is eroding as a result of increased competition and an ever-consolidating retail landscape that is increasing buyer power. In future years, they won’t enjoy the monopoly pricing power they once did because of the increased use of other, related products.

Narrow moat variety 2: firms with structural industry challenges

A company in this category dominates its peers, but resides in an industry where wide moats are nearly impossible to create. For example, Waste Management (WMI) has a solid position in the waste services industry. The trash taker is the largest operator of landfills in the country, a position that is nearly impossible to replicate due to political and citizens’ group opposition. Such barriers to entry in waste disposal are augmented by regional scale and route density on the collection side of its business, which makes life difficult for local independent haulers. This competitive position allows it to garner real pricing increases, which help to mitigate rising diesel fuel prices and cyclical declines in waste volume.

Wide moats

All things equal, one would choose a wide-moat company over a firm with a narrow-moat rating for the significant competitive advantages that should enable the wide-moat firm to earn more than its cost of capital for many years to come.

The advantage

Most wide-moat companies have some sort of structural advantage versus competitors. By "structural," we mean a fundamental advantage in the company’s business model that wouldn’t go away even if the current management team did. With a structural advantage, a company isn’t dependent on having a great management team to remain profitable. To paraphrase Peter Lynch, these are companies that could turn a profit even with a monkey running them, and it’s a good thing, because at some point that may happen.

The five types of moats are incredibly useful when thinking about structural advantages a company may or may not possess. Keep the five types of moats in mind:

• Low-cost producer or economies of scale
• High switching costs
• Network effect
• Intangible assets
• Efficient scale