Why the world’s best investors look for economic moats?

The thought of a moat often conjures an image in one’s head of a fortress surrounded by a channel of water. The obvious intent of the moat being to defend against attacks.

Economic moats are no different or any more complicated. An economic moat refers to a company’s ability to defend its profit making center(s) by surrounding itself with competitive advantages. As it relates to a company, economic moats can come in a variety of ways.

Knowing this alone, you can see why some of the world’s greatest investors seek economic moats. Warren Buffett coined or popularized the phrase economic moat as it relates to investing. The famed, American investor has pointed to such many times.

“A truly great business must have an enduring moat that protects excellent returns on invested capital. The dynamics of capitalism guarantees that competitors will repeatedly assault any business castle that is earning high returns. Therefore, a formidable barrier such as a company being the lowest cost producer or possessing a powerful worldwide brand is essential for sustained success. Business history is filled with ‘Roman candle’ companies whose moats proved illusory and were crossed.”

Warren Buffett – Berkshire Hathaway Annual Shareholder Letter 2007

Sources of moats

There are many ways for a company to insulate itself from free market competition and maintain its competitive advantages. What follows are the primary layers or sources of moats.

  • Network Effects – when the value of a product or service grows as the user base grows. Each extra customer increases the value of the product. Think social media and credit card networks.
  • Branding – one of the hardest moats to establish but one of the strongest when in place. This is also called mindshare ownership. Brands benefit from information advantage and social proof. Think established companies that you cannot live without and follow their releases with bated breath.
  • Economies of scale – companies that can produce goods at a lower cost than competitors are often able to sell at the same price as competitors and bank excess profits. Think big box retailers.
  • Switching Costs – switching costs lock in customers to unique ecosystems. Switching can involve expense and effort that are barriers to switching. Think technology network hardware or software infrastructure.
  • Counter Positioning – is where a new company or product is positioned in a way that incumbents do not compete in fear of damaging their current business. Think camera film companies when digital photography cam along.
  • Cornered resources – when a company has the upper hand with resources they gain power. Resource control can come from patents, licenses or access to physical resources. Think pharma or biotech.
  • Process Power – when a company is system driven that enables it to provide low-cost, quality products at a better price or more efficiently. This is something that is at the core of a business and deeply rooted. Often times manufacturing companies.

Who else is moat focused

While Buffett is the name that people recognize, plenty of other successful investor are moat focused. Moat investing is not a new approach. It’s been around for a long time but, only had a name put to the approach in the not too distant past.

In the UK, Terry Smith of the Fundsmith hedge fund is a great example of a moat investor. Terry has built an enviable track record of success with a foundation of finding quality companies. One of his primary focuses are seeking companies with competitive advantages and wide moats.

Here in the United States you will find names like:

  • Tom Marsico – Founder of the Marsico Fund Family who has had a stellar investing career
  • Ron Baron – Founder of the Baron Funds whose investor letters almost always point to his fondness for looking for moats.
  • Chuck Akre – Founder of the Akre Fund who is steadfast in searching for moats
  • The folks at Polen Funds

Caveats

While we are not fans of investing in mutual funds and ETFs, you will note that above we pointed to fund managers that are moat oriented. Contradictory? Not really. These folks have successful careers in managing money and credit must be given for such. In our post Why you should drive your portfolio we explain why we prefer to own stocks directly versus using pooled investments like funds.

If you have not caught on already, competitive advantages often equal moats. Not all competitive advantages are moat sources. But, all moats are born from competitive advantages.

Please keep in mind that investing in companies with moats is meant for people that have a buy and hold approach to investing. The reason for this is that companies with moats will not be shooting stars that provide quick pops. Rather, they will often prove to provide consistent returns over ‘long’ stretches of time.

If you’re a trader that does a lot of buying and selling this approach is not going to be of interest to you.

In our next post, What is moat investing?, we discuss why the current environment is perfect for taking control of your investments.

This website and associated newsletter along with its content/links are not financial advice. Nothing in this newsletter is an investment recommendation. All content is created for entertainment, educational, or informational purposes only. My strong buy, accumulate, hold, reduce or sell opinions are exactly that – opinions. Be sure to do your own research for your own particular circumstances or higher a professional advisor.

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