A moat is the competitive advantages possessed by a business that protect it from competitors and allows them to earn a high return on equity over a sustained period of time. Like a moat protects a castle, competitive advantages protect successful businesses.

A simple example of a Moat

Imagine you lived near a beach and you know a lot of young families would like sand for a sand pit for their kids to play in. So you put a sign out on the street saying you will let these families fill up a bag of sand from the beach in front of your house for $10.

This turns out to be very popular and you have dozens of families lined up to give you $10 and fill up their bag with sand from the beach in front of your house. Every night the tide washes sand in to replace what was taken each day.

Your neighbor notices all the money you are making and decides he wants some of it for himself. It is a commodity, he can only compete on price. So he puts out his sign - but instead of charging $10, he charges $5. Suddenly everybody goes to his place to fill up their bag with sand, he is making all the money and you are making nothing.

So you change your sign. Instead of charging $10, you reduce your price to $2.

Your neighbor reduces his price to $1

And so it goes until you both compete away all the above average profits.

The problem is you did not have a Moat to protect your business.

But if you had a license from the city to say you were the only one allowed to let people fill up bags of sand from the beach - your neighbor would not be allowed to compete - you would have a competitive advantage, in this case a monopoly.

What makes a good moat?

A good moat has more than just water in it.

Why?

Because you want to be able to stop somebody who learns to swim from crossing the moat as well

So lets say you add crocodiles?

Well that would stop swimmers and non-swimmers alike, but not Crocodile Dundee.

So maybe you add Piranhas as well.

That is how a business builds a good moat

Most businesses have to build their moat first and then as they make money from the business, they invest in enhancements that make the moat harder and harder to cross.

The best moats have seen lots of competitors try to cross and fail. Each time the business examines the weaknesses that the competitor tried to breach and finds ways to strengthen them.