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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Narrow Moat

What it is:

Narrow moat refers to the size of a company's competitive advantage. The term is an adaptation of the term "economic moat."

How it works (Example):

Long ago, castles were traditionally part city and part defensive fortress. The moat was a key part of this defense; by surrounding the castle with water, the fortress was more difficult to penetrate. The wider the moat, the more difficult it would be to attack a castle's defenders.

Likewise, an economic moat is a competitive advantage that is difficult to copy or emulate, thereby creating a barrier to entry for competing firms. Common economic moats include patents, brand identity, technology, buying power and operational efficiency.

Companies are not unlike medieval castles. A successful company will undoubtedly attract competitors. After all, it's only natural for companies to try to emulate success by copying their most profitable competitors. If those competitors are successful in gaining market share, then they'll erode the profitability of the original business.

Thus, the most successful firms are those that boast some sort of sustainable competitive advantage -- an advantage that's difficult to copy or emulate. These firms are able to maintain their success despite the inevitable attacks from competitors. Companies with wide economic moats operate business models that are difficult -- or in some cases even impossible -- for competitors to attack or emulate. Companies with narrow moats – well, they don't have that advantage.

Why it Matters:

A narrow moat makes it difficult to sustain above-average profitability. Narrow-moat firms can show tremendous growth for a period of time -- growth that prompts investors to jump aboard. Inevitably, however, competitors cross that narrow moat and attack the castle's advantage, eroding profitability.

One classic example of this is Palm. This firm's personal digital assistants (PDAs) took the market by storm back in the late 1990s. The company's Palm Pilot line of handhelds were bestsellers back in 1998 and 1999. But by 2001, several major competitors had entered the market. Hewlett-Packard (HPQ) introduced a new line of handhelds, as did Sony (SNE) and Research in Motion (RIMM). Mobile phone companies began integrating PDA-like elements into their handsets. The result: Palm's product quickly became a commodity, and the firm's growth soon evaporated.

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