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

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

Are we talking about stately homes?

Not quite. A moat, a deep ditch, usually filled with water, was a means of defending a medieval castle from attack. An economic moat, made up of attributes such as pricing power and strong brands, is said to protect a 21st century company 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 of products or services.

Pricing power is particularly useful in an era of breakneck inflation, although higher food prices are giving rise to accusations that companies are indulging in ‘inflationary greed’.

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

Who coined the term moat?

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

Buffett and his business partner Charlie Munger value a moat above almost anything else. Munger states, “It’s better to buy a great company at a fair price than a fair company at a great price.”

What 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 first to deliver certain iconic devices like the iPad, iPhone, and iPad.

Why are moats in the news?

One reason is controversy surrounding an email that surfaced earlier this year that is said to have been written by an anonymous member of Google’s Alphabet group.

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

The email was made public after the launch of ChatGPT, the generative AI system created by start-up 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.

To date, Alphabet’s moat has been seen to be based on the “network effect”: the more customers a company has, the more valuable its services are seen to be, especially since it can collect data on 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 interests in some of these. An exchange-traded fund (ETF) VanEck Morningstar Global Wide Moat invests only in companies in this category. But while a moat is a great asset to a business, it is not a guarantee of outperformance in stock price.