By most accounts, it was investing superstar Warren Buffett who first used the term “moat” to gauge the quality of an investment, but it’s a useful concept for ordinary investors as well.
Like the barrier protecting a castle, a wide moat makes an investment safer, a narrow one not so much. Since some moats are better than others. Investors are wise to look at factors that could enable the moat to last for years, or allow it to drain away at just the wrong moment. A patent preventing competitors from making the same product may be the most secure type of moat, far stronger than simply being first to produce something anyone else can improve upon, like the early search engines blown away by Google (Nasdaq: GOOG, GOOGL).
“I believe it is the single most important factor for an investor to consider in a long-term investment,” says Robert R. Johnson, president of the American College of Financial Services in Bryn Mawr, Pennsylvania.
“An economic moat is what allows a firm, even in a very competitive industry, to have a business model that stands the test of time,” Johnson says. “Warren Buffett has often used imagery recalling the Middle Ages, stating that he wants to invest in businesses with economic castles protected by unbreachable moats. This is a colorful way of describing a firm’s competitive advantage and assessing the durability of that competitive advantage.”
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Morningstar, the market data firm, makes extensive use of moats in assessing stocks and funds, and even has an index of stocks viewed as having wide moats — Morningstar Wide Moat Focus exchange-traded fund. ( MOAT).
Patents and brand names can be a moat that discourages competitors, as are network effects and cost advantages that allow a company to charge less than others in the sector, Morningstar says.
“Clearly, Apple is a firm that has several economic moats — high switching costs, network effect, scale and intangible assets,” Johnson says. “While Buffett indicated that Coca Cola ( KO) was the strongest brand name several years ago, one could argue that Apple ( AAPL) has surpassed Coke in terms of brand name. The network effect of Apple is exemplified by the fact that as more and more apps are created, the value of Apple’s products increase.”
But no matter how wide a firm’s moat is today, nothing is forever, Johnson warns.
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“For years, many investors considered Walmart ( WMT) as a prime example of a firm that had a fairly wide economic moat as a low-cost producer,” he says. “This allowed the firm to have an astonishing market share of over 10 percent of the enormous U.S. retailing market. Then Amazon ( AMZN) came along to chew at Walmart’s dominance.”
Within each category, some moats will be wider than others. So experts suggest looking more deeply into some key factors:
Legal standing. As mentioned, a patent, copyright or other legal barrier to competitors can be very valuable. Drugs that require governmental approval provide wide moats because the government will enforce the patent owner’s rights. But a patent offers less protection if, as many do, it allows other producers to patent products that improve on the original version. And a patent or copyright is no good at all if an unscrupulous competitor can simply ignore it with impunity, like a firm pirating DVDs of a blockbuster movie.
Unquantifiable assets. Those are factors like business culture that hard to measure but can strongly influence results. “One of the things I consider when investing is how well does the company partner or collaborate with others,” says Kristin Hull, CEO of Nia Global Solutions, a socially responsible investing firm. “So while they may have their own patents, or business model, working well with cities, governments, suppliers, other industry businesses can definitely be a competitive advantage.”
Cost. What would it cost a competitor to shoulder into the company’s market? Obviously, a low cost relative to the reward means a narrower moat, while a high cost, or “barrier to entry” is safer. “Some moats are capital intensive and keep competition away. You are not going to wake up one day and decide to manufacture cars,” says William Harris, president of the Financial Planning Association of Massachusetts.
Still, U.S. carmakers that once dominated have been challenged by firms from Japan, South Korea and other countries, so no moat is guaranteed to work indefinitely.
Acts of God. If the moat could be drained by an unpreventable event, it’s not so effective. Suppose the genius who founded the company dies or the tech wizards on the staff are lured away? What if new research shows the firm’s star drug has nasty side effects? Or what if a technological breakthrough makes your product obsolete?
“Moats that I look for are based more around company culture and the ability to attract and keep great talent,” Hull says. “Any executive could leave a company, so the operations need to continue regardless of one single individual.”
[See: 10 Ways to Invest in Pharmaceuticals With ETFs.]
“Bottom line, moats are mini-monopolies,” Harris says. “The stock may not go screaming through the roof, (as none are) risk free, but usually over the long haul they end up producing nice returns.”
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Consider a Moat When Choosing Investments originally appeared on usnews.com
