Economic Moat

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.

Companies are not unlike medieval castles. A successful company will undoubtedly attract 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. 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 rival.

Types of Moats
There are several ways to establish a wide economic moat. In some cases, companies can establish a cost leadership position within an industry. If a firm can offer products cheaper than any other firm, then it can drive its rivals out of business.

Wal-Mart (NYSE: WMT) is a perfect example of low-cost leadership in action. The company controls so much retail space that it's able to demand the lowest possible prices from suppliers. Because it would take decades of successful expansion for any firm to match Wal-Mart's tremendous size and scale, the company enjoys a sustainable advantage over its competition. In other words, it has a wide moat.

Another common moat involves a company's brand name and image. Consumers will continually reach for their favorite brands, paying a premium even if there are several cheaper generic equivalents on the market. A classic example is Coca-Cola (NYSE: KO). Although Coke contends with dozens of homogenous soft drinks, the company still manages to charge 20% to 30% more than generic brands. The reason: consumers identify with Coke and continually purchase their favorite brand.

The Dangers of Narrow Moats
A narrow moat makes it difficult to sustain above-average profitability. Narrow-moat firms can show tremendous growth for a period of time, but inevitably, competitors cross that moat and attack the castle's advantage, eroding profitability.

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