Why We Like Big Moats

Published in Investing Strategy on 20 January 2010

It's the secret to Warren Buffett's success.

Do you know the most important thing Warren Buffett looks for when evaluating a company?

It's not a debt-free balance sheet, a history of strong cash flow generation, or a strong corporate culture. It's not even an undervalued share price -- although that is certainly a hallmark of most Buffett buys.

Nope, the first thing Buffett looks for is an economic moat -- the bigger, the better.

The key to the castle

The term "economic moat" was one that Buffett himself coined. It simply refers to a business' competitive advantages that keep other companies at bay. Finding companies with significant, sustainable competitive advantages has been key to Buffett's phenomenal performance.

As the Oracle of Omaha told Fortune magazine:

"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

Emphasis on sustainable

Astute readers will notice that I placed special emphasis on the sustainability of a company's competitive advantage. I wanted to draw your attention to that point, because in business, most competitive advantages are short lived.

Just look at Rentokil Initial (LSE: RTO). In the early 1990s, the company was churning out annual earnings growth of 20%, year after year after year. But they had to make bigger and bigger acquisitions in order to keep hitting their lofty growth targets, and eventually bit off more than they could chew. Added to that, competition intensified in the hygiene and parcel delivery sectors, and before long Rentokil was a shadow of its former self.

Fame is fleeting

As Rentokil proved, audacious growth targets may be cool, but they are not a source of sustainable competitive advantage.

And according to hedge-fund manager and former Morningstar chief equities strategist Mark Sellers, the same can be said of a good management team, a catchy advertising campaign, or a hot fashion trend. These attributes may produce temporary advantages, but they are likely to erode over time, or be duplicated by competitors.

As far as Sellers is concerned, there are only four sources of sustainable competitive advantage -- the key to a true economic moat:

1. Economies of scale

This is a fancy term that economists love to throw around. Basically, it means that bigger companies can offer products at a lower cost than smaller ones can.

Tesco (LSE: TSCO) is the quintessential example of economies of scale in action. Because of its huge size, Tesco wields tremendous bargaining power over its suppliers and can spread its operational costs across a wide store base. The company can thus undercut its competitors on price and still turn a tidy profit.

2. The network effect

The network effect happens when the value of a service increases as more people use that service. For example, eBay becomes more useful as the pool of buyers and sellers grows -- although it also becomes increasingly difficult to snag that vintage mint-condition Rolling Stones 1972 US tour poster.

Network effects are also largely responsible for the success of credit-card companies such as MasterCard and Visa. After all, the more merchants that accept these cards, the more likely users are to carry them. Meanwhile, the more users that carry them, the more likely merchants are to accept them!

3. Intellectual-property rights

Companies such as AstraZeneca (LSE: AZN) and Shire (LSE: SHP) have been solid long-term investments, in large part because of the strength of their patent portfolios. These companies have proved to be adept at transforming the money they've spent on research and development into profitable products.

Truth be told, Unilever's (LSE: ULVR) products are actually pretty similar to those of its peers. However, people are more likely to buy Dove soap, Lux shampoo and Omo washing powder simply because they know and trust the brand.

4. High switching costs

You know a company has a wide moat when its customers stick around year after year -- even if they hate the product! For years, users have complained about Microsoft's software, yet the majority of the wired world runs on Microsoft products.

The reason is simple: It would be an enormous effort to retrain employees and transfer files over to a new format. And besides, everyone else uses Microsoft's software, too. Talk about a network effect!

Moat money

Finding a company with a wide and sustainable moat is a good start, but that's not enough to produce long-term market-beating returns. A bargain price is always imperative. 

In short, you want quality companies at bargain prices. Indeed that's what Maynard Paton and David Kuo search for in Motley Fool Champion Shares PRO, our real-money share tipping service. For a very short period of time, this service has reopened for new members. To get more information, simply click here.

More on the economy and the markets:

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> A version of this article was published originally on Fool.com. It has been updated by Bruce Jackson who has an interest in AstraZeneca.

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The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

2381nickp 21 Jan 2010 , 3:01pm

Yet another plug for Champion Shares PRO. There is a distinct air of desparation in the marketing now.

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