Understanding Economic Moats
An Economic Moat is fundamental aspect of a business that allows it to consistently create outsized returns from capital investment over the very long-term. It is not simply a competitive advantage (which is often superficial and fleeting), it is structural and often has a lot to do with the core underlying business model.
The focus on the long-term is important here… a business can have short-term returns that are much higher than those that are needed to signify an Economic Moat (say, incredible growth due to a new product launch), but those returns in and of themselves are not sustainable. An Economic Moat is fundamental to the business, and therefore lasts.
Typical types of Moats include: Intangible Assets (like brands & patents), Customer Switching Costs (think cell carriers…), Network Effects (on my list to do a full post on network effects), and Ingrained Cost Advantages (like proprietary processes & the effects of scale).
Interestingly, while many believe that an amazing management team can be an Economic Moat, Pat Dorsey (one of the main value-investors who helped coin the term) doesn’t believe so. The team is important, but simply not a structural aspect that represents a Moat.
One key insight comes from the VC Brian Laung Aoaeh of KEC Ventures. It is that Economic Moats are not intentionally created, they happen to a business. There certainly will be business models, products or industries that are naturally disposed to having the potential for Economic Moats to happen, but they are far from guaranteed. Economic Moats describe the situation that a business finds itself in… while they are the result of a great strategy that was seriously well executed, they are not the strategy in-and-of themselves.
The theory of Economic Moats is about judging the value of existing businesses for investment purposes — or in the case of startups: the value potential IF a Moat happens. Which if you think about who coined the term (value investing giants, such as Warren Buffet and Pat Dorsey), this view of the concept as a way to judge a business, not about a strategy to create, becomes obvious.
The advice, therefore, is that Entrepreneurs shouldn’t focus on creating Economic Moats. As is always true, they should only focus on creating an amazing product experience for their customers, that truly solves a strongly felt problem.
If you think about it, that makes perfect sense.
You can’t create the swell of usage that results in an Economic Moat, without first having an amazing product that provides a breakthrough experience for its users. The product comes first, Economic Moats simply fall out after flawless execution (if they’re meant to be, depending on the business model and broader situational factors). Entrepreneurs in the early stages need to understand Moats, but only to be able to recognize them as they happen, to better determine potential valuation.
So, there you have it. A bit about Economic Moats, and the role that they play in investing and entrepreneurial strategy: they are super powerful tools for valuation, but they aren’t a business strategy… they are the result.