First of all, let’s learn what an economic moat is.The concept of an economic moat was initially put forth by Buffett. An economic moat refers to the sustainable advantages that protect a company against its competitors. To understand this concept, just think of a company as a castle with a moat, where its competitors are like enemies attacking the castle. The wider and deeper the moat, the harder it is to capture, and hence the safer the castle. Therefore, a company with moats is better protected from its competitors, and is able to gain substantial revenue.The economic moat is a key factor that Buffett considers when selecting stocks. In his opinion, a company with moats is able to generate higher and more durable revenue for investors compared to the companies without moats. Economic moats protect a company from its competitors, allowing a company to maintain long-term profitability. Even when the company is suffering troubles in its operations, it can take advantage of moats to turn the tide and get through difficulties. By purchasing the shares of a company with economic moats, investors can benefit from a steady cash flow.Coca-Cola is one of the most typical examples. In 1985, Coca-Cola launched New co*ke, a co*ke with a new formula. Alongside this launch, the company announced that the traditional co*ke formula would be permanently discontinued. However, far from the expectations of Coca-Cola, the public’s reaction to New co*ke was negative. New co*ke was taken off the shelf only ten weeks after its launch. Again, in 2004, Coca-Cola launched C2, a cola-flavored beverage with half the calories found in traditional co*ke. However, the sales for C2 were also poor. Both New co*ke and C2 were complete flops that cost Coca-Cola a lot of money. Nevertheless, co*ke is still the first beverage choice of consumers due to its powerful brand. Also, the massive distribution channel of Coca-Cola prevents the company from threats by competitors. Thanks to the moats of its brand and distribution channel, Coca-Cola successfully got through its difficulties and maintained its competitive advantage.However, it is not easy for ordinary investors to find a company with moats. In reality, many of us could be deceived by “mistaken moats,” or traps, as moats are usually hidden. It’s hard to tell the real moats from illusory ones. There are three main traps: strong market share, great products, and talented CEOs. Let’s uncover them one by one.The first trap is strong market share. It is easy for us to assume that a company with a considerable market share is guaranteed to sustain its competitive advantage. However, as stressed by Dorsey, a high market share is not necessarily an economic moat. Kodak was founded in 1880 and was a giant in the photography industry with more than 100 years of history. In 1930, Kodak enjoyed 75% of the world’s photographic equipment market and earned 90% margins. Yet unexpectedly, Kodak, a giant with a vast market share ended up in bankruptcy. What was the reason? When the information age was approaching, Kodak still advocated film technology instead of pursuing digital imaging technology. Eventually, Kodak was surpassed in digital imaging technology by companies like Canon and Nikon. The company ultimately filed for bankruptcy in 2012.The second trap is great products. Great products rarely make a substantial moat. For example, Krispy Kreme is the second-largest doughnut company and coffeehouse chain in America, with more than 1,000 outlets all over the world. Their doughnuts are freshly-made and savory. Although Krispy Kreme makes great doughnuts, it is easy for consumers to switch to other brands or reduce their consumption. Therefore, great products do not necessarily make good enough moats to maintain a company’s long-term competitive advantage.The third trap is talented CEOs. We tend to take for granted that a company with a superb management team will certainly create high and stable revenue. However, is it true? Buffett made an insightful statement: “When management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Even the best engineer in the world can’t build a 10-story sandcastle, just like you cannot make bricks without straw. Similarly, a great CEO cannot do much for a company without any competitive advantage. Let’s look at the example of Conseco, once the largest insurance company in America. Before its bankruptcy, Conseco had been experiencing a financial slump for four years in a row. CEO Gary Wendt failed to turn Conseco around after two years of effort, despite having been a superstar at General Electric. In 2002, Conseco filed for bankruptcy. As Buffett points out, although these managers do not lack talent and a fighting spirit, management is just not as important as we think it is when it comes to economic moats.Alright, that wraps up the first part of this Bookey: what is an economic moat. Let’s summarize. Economic moats refer to the sustainable advantages that protect a company against its competitors. The value of moats lies in the ability to protect a company from its competitors, and allow the company to gain sustainable revenue. On the other hand, common mistaken moats, or traps, include strong market share, great products, and talented CEOs. A great market share does not grant a company solid moats. Similarly, great products do not prevent the risk that consumers choose another product, and it is difficult for a great CEO to save a company riddled with problems.
