Competitive moat

Definition

A competitive moat is what keeps competitors from copying a company’s advantage and, with it, the margin that advantage brings. Strategy scholars speak of barriers; investors call it a moat, the ditch of water around a castle.

A company can earn more than its competitors for many reasons: a better product, a lower cost, a closer relationship with customers. The moat is what makes that extra earning last. Without a moat, the advantage lasts only until the first attentive competitor finds a way to imitate it.

Competitive advantage and moat: the difference

The two ideas are often confused, but they answer different questions. A competitive advantage explains why customers choose one company over another. The moat explains why competitors, even when they see that advantage, cannot copy it.

A restaurant with a good cook has an advantage. If the place across the street can hire that cook for a slightly higher salary, it has no moat. The same goes for a company: a better product, a lower price or faster service are advantages, but they become a solid position only if something stops others from catching up quickly.

Where the idea comes from

The idea that an advantage has to be defended is as old as competition. In strategy it became a tool of analysis with Michael Porter. In 1979, in the Harvard Business Review, Porter named the threat of new entrants as one of the forces that decide how profitable an industry is, and barriers to entry as what keeps that threat low. Among the sources of barriers he listed economies of scale, product differentiation, the capital needed to enter, access to distribution channels and government policy.

More recently Hamilton Helmer, in his book 7 Powers (2016), tied the barrier to the advantage as an inseparable pair. For Helmer a strong position always has two parts: a benefit, which brings higher earnings, and a barrier, which stops others from cancelling it out by imitation.

The most common moats

Competitive moats take different forms. These are the most frequent.

• Scale: a large company spreads its fixed costs over more products and can sell at a price a newcomer cannot sustain.
• Switching costs: the customer would stay even in the face of a better offer, because changing supplier would cost time, money or risk.
• Know-how that is hard to imitate: skill built over years, often in people more than in machines.
• An exclusive resource: a patent, a license, a location, access to a raw material.
• Brand and reputation: the trust that lets a company charge a higher price without losing customers.

Moats in Italian small and mid-sized companies

In Italian small and mid-sized companies the moat is rarely scale. Much more often it is a person or a relationship: the technician who reads a drawing better than anyone else, the sales manager who has always known the customer’s purchasing office, the ability to deliver on schedules competitors cannot guarantee.

These are real moats, but fragile ones. They do not appear on the balance sheet, they depend on a few people, and often nobody has ever written them down. So the company risks weakening them without noticing: a departure nobody replaces, a cost cut, a new tool that makes easy for everyone what only this company used to know how to do.

An example

An example built on purpose, and stated as such. A company with fifty employees makes components for a large manufacturer of farm machinery. Its price is not the lowest on the market. Yet the customer has not changed supplier in fifteen years.

The reason is qualification. To get onto the manufacturer’s supplier list takes lab tests, factory audits and a year of trial deliveries. For the customer, changing supplier means starting all over again and risking a line stoppage. That switching cost is the company’s moat. The product matters, but it is qualification that keeps competitors away.

Two practical consequences follow. First, the company has to know that its real defense is the qualification, and keep investing in what maintains it (consistent quality, documentation, punctuality). Second, if the manufacturer simplified its qualification rules, the moat would drop for everyone, and the company would be left competing on price alone.

When the moat looks like a cost

The most insidious case is a moat that shows up in the accounts as an expense. American newspapers saw the printing press and the distribution network as costs to cut. In reality they were what made each paper the only place in town to run a classified ad. When the internet made paper unnecessary, the moat fell too, and with it much of the revenue from classifieds.

Artificial intelligence carries the same risk today: a tool that cuts a cost can, at the same time, lower the moat that protected the margin. Before cutting a cost line, it is worth asking whether it is also a defense.

How to recognize a moat

A simple question helps: why do customers choose us, and why can a competitor not do the same? The first half of the answer describes the advantage. The second describes the moat. If the second half stays empty, the advantage has an expiry date.

It is worth checking the answer outside the company too, with a customer who stayed when they could have left, or with someone who tried to win that customer away. People inside tend to overrate some defenses and not see others.

The role of the business strategist

The business strategist’s job is to help the owners see which moats hold up the company’s margin, which are weakening and where it makes sense to build new ones. It is a central part of business strategy: deciding what to do and what not to do also means deciding what to defend. The value stick helps place the moat in the wider picture of value: the moat is what lets the company keep a wide gap between the customer’s willingness to pay and its own costs.

Frequently asked questions

What is the difference between a competitive moat and a barrier to entry?

A barrier to entry concerns a whole industry: it is what makes it hard for a new company to enter the market, such as the capital required or licenses. A competitive moat concerns a single company: it is what stops competitors, including those already in the market, from copying its advantage.

Can a small company have a competitive moat?

Yes, and it often has one without knowing it. In Italian small and mid-sized companies the moat is usually know-how that is hard to imitate, a qualification with an important customer or a relationship built over time. According to Andrea Barchiesi, business strategist, the first step is to write it down, because a moat nobody has named is also a moat nobody protects.

How can you tell a moat is weakening?

The most common signs are three: customers ask for discounts they did not ask for before, a competitor offers the same thing faster, or a key person is about to leave the company. Each of these signs deserves a precise question: what has been protecting us so far, and does it still?

Sources

• Michael E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review, March–April 1979
• Hamilton Helmer, 7 Powers: The Foundations of Business Strategy, 2016
• Robert Seamans, Feng Zhu, “Responses to Entry in Multi-Sided Markets: The Impact of Craigslist on Local Newspapers,” Management Science, 2014