In medieval times, kings lived in castles that were often surrounded by water known as moats. These castles were designed with a sole purpose: to protect the king. If under attack, the castle's defenses made it very difficult and time-consuming to capture the king.
The concept of a moat is equally valuable in business. Like a castle's moat, a company's moat is an attribute particular to that company that allows it to defend itself successfully against competitors. Put another way, moats allow for sustainable profitability that, in turn, create the optimal scenario for sustainable value creation. Warren Buffett says, "The most important thing to me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles."
In the business world, moats are very difficult to construct. The most obvious moat was the monopoly. I use the past tense because monopolies are effectively illegal today. But if you go back and consider some of the most profitable businesses in U.S. history -- Carnegie Steel, Standard Oil, and J.P. Morgan -- all started as virtual monopolies. Nearly all the country's oil was moved using Standard's pipelines, the steel used to build the country was from Carnegie, and the most powerful financier in the land was John Pierpont Morgan. To give you an example of just how profitable these companies were, consider that today's Exxon Mobil (XOM - Get Report), ConocoPhillips (COP - Get Report), and Chevron (CVX - Get Report) all used to be part of Standard Oil.
The next best thing to a monopoly is an oligopoly, where an industry is dominated by a few names. UPS (UPS - Get Report) and FedEx (FDX - Get Report) have a duopoly in shipping; Home Depot (HD - Get Report) and Lowe's (LOW - Get Report) in home improvement; Coca-Cola (KO - Get Report) and PepsiCo (PEP - Get Report) dominate soft drinks; and the fertilizer industry has the triumvirate of Potash (POT - Get Report), Mosaic (MOS - Get Report) and CF Industries (CF - Get Report).Another moat (though slightly weaker but nonetheless valuable) is the first-mover advantage. Apple (AAPL - Get Report) is the best recent example of this. With the launch of the iPhone, Apple created a new market for mobile communications and had this market virtually to itself for years. Look back at Apple's gross margins when the iPhone first came out compared to today and you can appreciate the value of being a first mover. Naturally, such large margins invite competition, which, over time, breaches the moat.
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