Warren Buffett believes the best investments are in companies with strong economic moats – sustainable competitive advantages that protect businesses from competition. The term ‘economic moat’ was popularised by Buffett himself, drawing an analogy between medieval castles and businesses. Just as a moat protects a castle from invaders, an economic moat shields a company from competitors that seek to erode its market share, pricing power and profitability.
Buffett prioritises businesses with economic moats because they offer long-term stability, pricing power and above-average returns on capital. Companies with wide moats can fend off competition, maintain strong profit margins and generate consistent cash flows, making them ideal long-term investments. Without a moat, even a well-run company with strong revenues can fall victim to industry disruption, pricing pressures or new entrants willing to undercut margins.
Buffett's approach is clear: Buy great businesses with durable moats at fair prices and hold them for the long run. For investors looking to apply Buffett’s philosophy, understanding how to recognise and evaluate economic moats is essential.
TYPES OF ECONOMIC MOATS BUFFETT SEEKS
Brand power: Companies that dominate through customer loyalty
A powerful brand creates a psychological moat in the minds of consumers, allowing a company to charge premium prices and maintain a strong competitive position. Buffett is a firm believer in investing in businesses with deeply entrenched brands that inspire trust and customer loyalty.
Coca-Cola is one of Buffett’s most famous investments and for good reason. The brand is recognised worldwide, giving it pricing power – the ability to raise prices without losing significant customers. This brand strength is reinforced through marketing, habitual consumption and emotional connection with consumers. Buffett often highlights Coca-Cola as an example of a company with an unassailable moat that has lasted for decades.
Another example is Apple, which Buffett added to Berkshire Hathaway’s portfolio in 2016. While Apple operates in a technology-driven industry, its brand power extends far beyond its products. Apple’s ecosystem, combined with intense customer loyalty, allows it to charge premium prices and sustain strong margins.
For investors, the lesson is that companies with strong brand recognition and customer loyalty can maintain pricing power and profitability over the long run.
Cost advantages: Businesses that operate more efficiently than competitors
Companies with a cost advantage can produce goods or services at a lower cost than competitors, allowing them to maintain strong profit margins even in highly competitive markets. Buffett values businesses that can sustain cost leadership without sacrificing quality, as this ensures resilience during economic downturns.
Walmart is a prime example of a company with a cost advantage. Its economies of scale, supplier relationships and operational efficiency enable it to offer lower prices than smaller competitors. This moat has helped Walmart maintain its dominance in the retail sector despite challenges from e-commerce giants like Amazon.
Another Buffett investment with a cost advantage is GEICO (Government Employees Insurance Company). GEICO operates with a direct-to-consumer business model, eliminating the need for expensive insurance agents. This allows it to offer lower premiums than competitors while maintaining profitability. Buffett saw this advantage early and acquired full ownership of GEICO in 1996, turning it into one of Berkshire Hathaway’s most valuable subsidiaries.
For investors, identifying businesses with sustainable cost advantages involves analysing operational efficiency, supply chain strength and pricing flexibility. Companies that can lower costs while maintaining quality often have a durable moat.
Network effects: Businesses that become more valuable as they grow
A network effect occurs when the value of a product or service increases as more people use it. Companies with strong network effects create high barriers to entry, making it difficult for new competitors to gain traction. Buffett has invested in several businesses that benefit from network effects.
One example is American Express, a company Buffett has held since the 1960s. As more merchants accept American Express cards, more consumers are incentivised to use them, reinforcing the company's competitive position. The brand’s premium reputation, high-spending customer base and exclusive benefits further strengthen its moat.
Another network effect investment is Moody’s Corporation, a credit rating agency. Financial institutions, investors and companies rely on Moody’s credit ratings to assess risk. Because its ratings are widely accepted in global financial markets, the company enjoys an embedded network moat that makes it difficult for competitors to replace it.
For investors, identifying network effects involves analysing customer adoption rates, switching costs and industry reliance on a company’s services. Businesses with strong network effects tend to scale efficiently and remain industry leaders.
High switching costs: Businesses that are difficult to leave
Companies with high switching costs create friction for customers who want to move to a competitor. If a customer must invest significant time, money or effort to switch providers, they are more likely to stay loyal, even if competitors offer lower prices.
Buffett favours businesses with built-in switching costs that create long-term customer retention and pricing stability. One such example is Moody’s – financial institutions and corporations rely on its credit ratings and transitioning to an alternative rating agency could be costly and time-consuming.
Another example is Microsoft, particularly in its enterprise software and cloud computing divisions. Businesses that rely on Microsoft Office, Azure and enterprise solutions face integration challenges and productivity losses if they switch to another provider. As a result, Microsoft enjoys high customer retention rates and sustained pricing power.
For investors, businesses with high switching costs tend to have consistent revenue streams, strong customer loyalty and high renewal rates, making them excellent long-term investments.
Regulatory protection: Businesses with government-backed advantages
Certain industries benefit from regulatory protection, creating government-enforced moats that make competition difficult. Buffett has invested in companies that enjoy monopolistic or oligopolistic market positions due to legal or regulatory advantages.
A prime example is utility companies, such as Berkshire Hathaway Energy. In many regions, utility providers operate with government-granted monopolies, preventing new competitors from entering the market. These businesses generate stable revenues and face little disruption from industry newcomers.
Another example is health insurance and financial institutions, where regulatory requirements create high barriers to entry. Companies that operate in heavily regulated industries often have predictable earnings and strong pricing power.
Investors looking for regulatory moats should consider industries with high compliance costs, strict licensing requirements and limited competition. These companies tend to offer stability and strong profit margins.
HOW INVESTORS CAN IDENTIFY ECONOMIC MOATS
Key financial indicators of a strong moat
While qualitative analysis is important, investors can use financial metrics to assess whether a company has a durable moat:
High return on equity (ROE): Consistently high ROE suggests a company is using capital efficiently.
Stable or growing profit margins: Companies with strong moats tend to maintain healthy profit margins despite competition.
Consistent free cash flow (FCF): Businesses with steady FCF have pricing power and financial flexibility.
Low customer churn rates: High customer retention suggests strong brand loyalty or switching costs.
Assessing the durability of a moat
A company may have a moat today, but investors must determine if it can be sustained over time. Factors to consider include:
Industry trends: Is the business model at risk of disruption?
Competitive threats: Are new entrants threatening the company's dominance?
Management decisions: Is leadership reinvesting in the company’s strengths?
Companies that continuously reinvest in their moat tend to outperform over the long run.
Buffett’s success proves that businesses with strong moats offer the best investment opportunities. By identifying companies with brand power, cost advantages, network effects, high switching costs and regulatory protection, investors can build portfolios that withstand competition and market fluctuations. Economic moats are the foundation of Buffett’s investing philosophy – and they can be yours too.
This Trustnet Learn article was written with assistance from artificial intelligence (AI). For more information, please visit our AI Statement.