What it means
The moat idea was popularised by the investor Warren Buffett, who looks for businesses with durable advantages that rivals struggle to copy. Those advantages can include a strong brand, high switching costs for customers, a cost advantage, a network effect or valuable licences and patents.
The wider and deeper the moat, the harder it is for competitors to take away the profits. The research firm Morningstar turned the idea into a rating scheme with three levels: no moat, narrow moat and wide moat.
In its approach, a narrow moat means the firm is more likely than not to keep earning returns above its cost of capital for at least 10 years, while a wide moat means it is expected to do so for at least 20 years. The ratings are an opinion based on analysis, not a measured fact, and different firms use different time horizons.
A narrow moat sits in the middle. The company has some edge, perhaps a respected brand in a niche or a modest cost advantage, but the edge is easier to challenge.
A new technology, a well-funded entrant or a change in customer taste could narrow it further. Why does this matter to a manager?
Because the length of time that excess profits can last drives how much an investor is willing to pay for the company. A business with a wide moat can justify a higher valuation multiple than one with a narrow moat, even if their current profits are identical.
It also matters for your own strategy. If your company has only a narrow moat, the sensible response is to spend on whatever widens it, such as customer loyalty programmes, proprietary data or lower unit costs, rather than assuming today's margins will last.
Remember that a moat is a judgement about the future. Analysts disagree, ratings change, and a company can lose its moat faster than expected when its industry shifts.
Treat the label as a prompt for questions about durability, not as a final answer.
In practice
Real-world examples.
Example
A regional bakery chain has loyal customers and a handful of prime high-street sites. A competitor with deeper pockets can still open nearby, so an analyst rates the chain as having a narrow moat and models its excess returns fading over about a decade.
Example
A software company sells accounting tools to small firms, with moderate switching costs because customers must re-enter data to change supplier. The investment team gives it a narrow moat and pays a modest premium to the market multiple, not the large premium it would pay for a dominant platform.
Example
A manufacturer of industrial valves has long-standing contracts with oil and gas operators but little pricing power. Its management team studies the moat concept in a strategy workshop and decides to invest in service contracts that lock in customers for longer.
Case study
Seen in the real world.
Sandpiper Coffee is an illustrative, fictional chain of 120 cafes with a loyal local following. Its owners assumed that the brand alone would protect margins forever, and budgeted for no new investment in customer loyalty.
A large international rival then opened 40 outlets in the same cities with a cheaper menu, and Sandpiper's operating margin slipped from 14% to 9% within two years. A visiting investor, using a moat framework, described the business as having a narrow moat that was already narrowing.
In this illustrative story the board responded by launching a mobile ordering app, a subscription scheme and a supplier agreement that cut coffee costs. The case shows that a narrow moat is not a permanent state and must be worked at, and that managers should test their own advantages against the best-funded rival.
Watch out
Common mistakes.
- Assuming a narrow moat means a weak or bad company, when it simply means advantages are expected to last for a shorter period.
- Treating a moat rating as a precise measurement, when it is an analyst's judgement and can change.
- Paying any price for a company because it has a moat, when valuation still matters.
Questions
People also ask.
What is the difference between a narrow and a wide moat?
A narrow moat is expected to protect returns for roughly a decade, while a wide moat is expected to protect them for around twenty years.
What creates a moat?
Sources include brand strength, switching costs, network effects, cost advantages and intangible assets such as patents and licences.
Can a moat disappear?
Yes, technology shifts, new regulation or aggressive competitors can erode a moat, which is why analysts review ratings regularly.
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