Moat Investor

What is a Moat?

As you can tell by our name – Moat Investor – we think the concept of an economic moat is the most important element of our investing philosophy. An economic moat, or significant competitive advantage, is the key to long-term returns.

Warren Buffett first coined the concept of an “economic moat” and he often refers to “economic castles” protected by “unbreachable moats” in his Bekshire Hathaway shareholder letters. Moats keep competitors from stealing market share and thus stealing future cash flows. The wider the moat, the more predictable your return. Competitors are constantly attacking your customers with cheaper knock-offs and new value-adds, so it takes a wide moat to pull in consistent growth figures year after year.

Here are some ways a company can establish a moat:

Brand differentiation: The product has such a dependable “brand contract” with customers that you are willing to pay a higher price in working with them. Think Coke, Volvo, Nike, Harley-Davidson, SC Johnson or even the rock band U2.

Intellectual Property: A patent, copyright or trade secret that makes it very difficult or even illegal to compete with the company. Think Intel, Dow, 3M, Amazon, successful Big Pharma companies.

Velocity: The company is committed to gaining, sustaining and surviving hyper-growth and thus through constant innovation is faster than all of their competitors in both mindshare and new brand extensions. Think Starbucks, Alliance Data, and Google.

Monopoly-like Market Share: When a company has almost exclusive control over a market meaning they can collect a tax or a price upgrade on every transaction. Think utility company, airlines, cable and broadcasting companies, motion picture distributors.

Loyalty: the company is so ingrained in your life or business that it would be more expensive to work with a competitor than to pay a premium. Think Microsoft, ADP, Netflix, materials management companies.

Extraordinary Value: a company that through market dominance or operational excellance can outprice its competitors or offer more value for the same price. Think Wal-Mart, Lowes, Target, Kohls, Jos A Banks.

Moat Investors – particularly investors interested in technology and new product development – should be wary of identifying the differences between castles and moats. Palm (PALM) had a huge headstart in building a castle in the late 1990s with the introduction and wide adoption of the PDAs. Their market cap soared to about $30 billion in late 2000. They’re market cap in August 3, 2006 is $1.5 billion. Not shabby, but a small fraction of their past glory. If you bought in at $15 billion thinking you had a considerable Margin of Safety, you would have lost 90% of your value. The key point with Palm is that they built a great castle – an innovative business tool with a high gadget-geek quotient – but failed to protect it with a moat.

You can blame some of the drop on the bubble bursting in 2000, but in fact it wasn’t long before competitors like Handspring (HAND), Sony (SNE), and Hewlett-Packard (HPQ) introduced their own versions of the PDA. This crushed Palm’s margins and made them less predictable, thus less valuable. Today, cell phone software is replacing the PDA and Palm is fighting back with PalmOne and the Treo. But will they be able to build a moat that Microsoft or Apple cannot traverse with their new phones? Unlikely.

Moats are the most important consideration in your investing strategy, but the hardest to evaluate. Go beyond the flash of new product development and make an estimate of the sustainability of the competitive advantages for each company in your portfolio.