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

In this series, we break down the jargon and explain a popular investment term or theme. Here are the moats.

Are we talking stately homes?

Not exactly. A moat, a deep ditch, usually filled with water, was a means of defending a medieval castle from attack. An economic moat, consisting of traits such as pricing power and strong brands, would protect a company from competition in the 21st century.

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

What is Pricing Power?

A company has pricing power if it can raise prices without losing sales for products or services.

Pricing power is especially useful in an era of skyrocketing inflation, although higher food prices are leading to accusations that companies are indulging in “greed.”

Switching power is another important element of a moat. For example, customers of a software company may consider switching to a rival, but will be put off by concerns about data loss and service disruption.

Who coined the term moat?

Warren Buffett, veteran manager of the $744bn (£579bn) Berkshire Hathaway fund, coined the term in 1999. He says, “A truly great company should have a lasting moat that protects an excellent return on invested capital” and will only invest in such companies.

Buffett and his business partner Charlie Munger protrude a moat above almost everything. Munger says, “It’s better to buy a great company for a fair price than an honest company for 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 company the fund owns, thanks to the special qualities of the moat.

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

Why are canals in the news?

One of the reasons is the controversy surrounding an email that appeared this year that is said to have been written by an anonymous insider at the Google group Alphabet.

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

The email was made public after the launch of ChatGPT, the generative AI system from startup OpenAI, in which Microsoft has a stake.

But according to the email, even OpenAI may not have a moat, given the rise of low-cost “open source” models.

Until now, Alphabet’s moat has been seen as based on a ‘network effect’: the more customers a company has, the more valuable its services are deemed, especially since it can collect data from these customers.

What about UK companies?

Names such as BAE, British American Tobacco, Diageo, the London Stock Exchange and Unilever are often mentioned.

The Finsbury Growth & Income trust has interests in a number of these. An Exchange Traded Fund (ETF) VanEck Morningstar Global Wide Moat only invests in companies in this category. But while a moat is a big plus for a company, it doesn’t guarantee superior price performance.