Economic Moat

“A good business is like a strong castle with a deep moat around it. I want sharks in the moat to keep away those who would encroach on the castle.” - Warren Buffett

Warren Buffett uses moat, a deep wide ditch surrounding a castle built to prevent invasion, as a metaphor to describe competitive advantages of businesses that allow them to generate superior return on invested capital compared to their peers for a long period.

One way to measure economic moat of a business is to compare its ROIC (return on invested capital) with WACC (weighted average cost of capital: combined cost of debt and equity). WACC can be considered the next best alternative rate of return a business can generate with same risk by investing elsewhere. If a business is consistently generating positive ROIC - WACC spread, the law of regression to the mean states that the business’ ROIC will decline towards the WACC and the spread will vanish. When a business consistently generates an ROIC greater than its WACC, it faces competition from new entrants. High profitability of a business is magnet for competition. If the business defies the law of regression to the mean and continues to generate positive ROIC - WACC spread for a long time, it’s because the business has an economic moat (e.g. differentiated product, low-cost production, network effect, strong brand, high barriers to entry).