Why moats are so important

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A moat is a competitive advantage that one company has over the other companies in the same industry. The term was coined by the renowned investor Warren Buffett.

The wider the moat, the company would enjoy larger and more sustainable profits over its competitors. A well-known brand name, pricing power and a large market share leading to economies of scale are some of the moats which would allow companies to enjoy high returns over the long term.

Let us take the example of Eicher Motors to understand this. 'Royal Enfield' is the premium motorcycle brand of Eicher Motors. Royal Enfield largely caters to the mid-sized 250 cc to 499 cc segment. The major part of their sales comes from the 250-350 cc bikes such as 'classic', 'thunderbird' and 'bullet'. They enjoy a 99.5% market share as per the data reported by Society of Indian Automobile Manufacturers. The brand was selling 50,000 bikes in the year 2010 and in 2014 the figure touched 3,00,000. The volumes have increased nearly by six times over the past five years. So the strong brand name and a dominant market share have created a strong economic moat for Eicher Motors.

However, there would be certain companies wherein it would be difficult to understand the industry and find out the economic moat of the same. For example, it would be difficult to find the moat involved in the technology sector as it is difficult to understand the sector. This was the case with Berkshire Hathaway led by the iconic CEO Warren Buffett. The company did not have much exposure to the technology stocks, till recently when it increased its stake in International Business Machines Corp (IBM) and currently it occupies the 3rd most valuable spot in the company's portfolio. Buffett in an interview to CNBC stated that he knew a lot less about the technology sector as compared to the consumer or the financial sector. The moat he stated while choosing IBM over other rivals was the hybrid cloud that the company offered, large and well established set of clients, dividend payout ratio and high switching costs.

High switching cost is also an economic moat. Switching costs are those one-time inconveniences or expenses a customer incurs in order to switch over from one product to another. If you've ever taken the time to move all of your account information from one bank to another, you know what a hassle it can be. Similar is the case in the technology sector wherein moving to another technology involves high cost of training and hardware to suit the new software requirements. This plays an important moat in the technology sector and that was possibly one of the reasons why Berkshire Hathaway invested in IBM as it has well established client base.