INVESTING EXPLAINED: What you need to know about moats, shielding a 21st century business from competition

INVESTING EXPLAINED: What you need to know about moats, shielding a 21st century business from competition

In this series, we bust the jargon and explain a popular investing term or theme. Here it’s moats. 

Are we talking stately homes?

Not exactly. A moat, a deep ditch, usually filled with water, was a means to defend a medieval castle from attacks. An economic moat, made up of such attributes as pricing power and strong brands, is said to shield a 21st century business from competition.

In tough times, a moat, preferably as wide as possible, should protect a company’s profit margins.

What constitutes pricing power?

A company has pricing power if it can raise prices without suffering any loss in sales for products or services.

Pricing power is particularly useful in an era of soaring inflation, although higher food prices are leading to accusations that companies are indulging in ‘greedflation’.

Protection: In tough times, a moat should protect a company’s profit margins

‘Switching power’ is another key element of a moat. For example, customers of a software company may contemplate switching to a rival, but will be deterred by concerns over data loss and disturbance of service.

Who coined the term moat?

Warren Buffett, veteran manager of the $744billion (£579billion) Berkshire Hathaway fund, used the term in 1999. He says: ‘A truly great business must have an enduring moat that protects excellent returns on invested capital’ and will only invest in such companies.

Buffett and his business partner Charlie Munger prize a moat above almost everything. Munger contends: ‘It is better to buy a great company at a fair price than a fair company at a great price.’

Which companies have a moat?

Berkshire Hathaway’s largest holdings provide a clue. They are: Apple, Bank of America, American Express, Chevron, Coca-Cola and Kraft Heinz. Buffett calls Apple the best business the fund owns, thanks to the particular qualities of its moat.

Apple has pricing power and superior designs, but its competitive advantage has also been increased by being the first to deliver certain iconic devices like the iPad, the iPhone and the iPad.

Why are moats in the news?

One reason is the controversy surrounding an email that emerged this year which is said to have been written by an anonymous insider at Google group Alphabet.

This alluded to its concerns that it lacks a moat in the AI (artificial intelligence) field, which could be worth £1trillion by 2033.

The email was made public following the launch of ChatGPT, the generative AI system created by the start-up OpenAI, in which Microsoft has a stake.

But, according to the email, even OpenAI may not have a moat, given the rise in low-cost ‘open source’ models.

To date, Alphabet’s moat has been seen to be based on ‘network effect’: the more customers a company has, the more valuable its services are deemed to be, especially as it can collect data from this clientele.

What about UK companies?

Names like BAE, British American Tobacco, Diageo the London Stock Exchange and Unilever are often cited.

The Finsbury Growth & Income trust has stakes in some of these. An exchange traded fund (ETF) VanEck Morningstar Global Wide Moat invests only in companies in this category. But, although a moat is a major plus for a business, it is no guarantee of superior share price performance.