The idea of an economic moat refers to how likely companies are to keep competitors at bay for an extended period. One of the keys to finding superior long-term investments is buying companies that will be able to stay one step ahead of their competitors, and it's this characteristic—think of it as the strength and sustainability of a firm's competitive advantage—what we're trying to capture with the economic moat rating.
One of the first things we do when we're thinking about the size of a firm's economic moat is look at the company's historical financial performance. Companies that have generated returns on capital higher than their cost of capital for many years running are usually have a moat, especially if their returns on capital have been rising or are fairly stable.
Of course, the past is a highly imperfect predictor of the future, so we look carefully at the source of a company's excess economic profits before assigning a moat rating. For example, a competitive advantage created by a hot new technology usually isn't very sustainable, because it won't be too long until someone comes along and invents a better widget.
Here are some of the attributes that can give companies economic moats:
Huge Market Share: When a firm enjoys economies of scale in areas like manufacturing, sales, and marketing, it can be pretty tough for a competitor to catch up.
Low-Cost Producer: The ability to produce products or services at a lower cost than competitors is an advantage that's especially potent in commodity industries.
Patents, Copyrights, or Governmental Approvals and Licenses: Some companies generate enormous profits when their products or markets are artificially protected by the government.
Unique Corporate Culture: Although you should be careful of placing too much emphasis on this attribute, since it's such a "soft" method of determining competitive advantage, there's no question it can make a difference.
High Customer-Switching Costs: If you can make it tough for your customers to use a competitor, it's usually easy to keep ratcheting prices up just a bit year after year--which can lead to big profits.
The Network Effect: This is a relatively rare, but potentially quite potent, source of competitive advantage, and often accrues by the first mover in an emerging technology. Since a network's value increases as more people use it, the company that creates the network can create a massive economic moat.