In ancient and medieval times, castles and even entire towns often built a moat — a deep ditch filled with water — as a preliminary line of defense to deter the enemy.
The same technique is essential in the world of equity investing, too. In a capitalistic society likes ours, you can be sure that if someone has found a profitable niche, it isn’t long before others show up to exploit it. This is generally a positive development for consumers who quickly see prices plunge. But it’s a different matter for business owners who just as regularly see profit margins wither up and die.
Two prime examples are Circuit City and Borders. The first sold consumer electronics; the latter books, music and DVDs. Both had razor-thin operating margins and virtually nothing to protect them from competitors, either online or in the brick-and-mortar world. Selling commodity products available from anyone, both wound up in bankruptcy.
What provides an effective moat in our competitive marketplace? A few examples are patents, trademarks, brand names, regulatory complexity and huge economies of scale.
Examples of effective moats
Take patents, for example. One of the reasons for Apple’s (Nasdaq: AAPL) extraordinary success is that most of its products are patent-protected. The Mac operating system is not licensed to other vendors. And iPods, iPhones and iPads have many patent protections, too. (Some of these are currently being disputed in court with Samsung.) Likewise, a former big winner in The Oxford Club’s Trading Portfolio was Intuitive Surgical (Nasdaq: ISRG), a company with a patented monopoly on the manufacture and sale of surgical robots.
Another effective moat is early adoption. This has been a huge benefit for Amazon (Nasdaq: AMZN) and Google (Nasdaq: GOOG). When I shop online, I don’t even bother checking other retailers. If I do a search, it’s always through Google. A service becomes increasingly valuable as more people adopt it.
Coca-Cola (NYSE: KO) is a company whose business is protected by brand names. Coke offers quality and reliability in all its products, something that isn’t generally established with upstart soda companies.
Altria (NYSE: MO) actively supports much federal government regulation of the tobacco industry. Why? Because it knows regulatory hurdles and liabilities deter potential competition. Tough regulatory oversight is itself a moat.
Other companies benefit from sheer economies of scale. Wal-Mart (NYSE: WMT), BHP Billiton (NYSE: BHP) and General Electric (NYSE: GE) are just a few examples. Their bargaining power with suppliers, state-of-the-art technology and access to ultra-low-cost financing allow them to underprice – and thereby deter – a lot of potential competition.
The last thing you want to do…
Investment great Warren Buffett declares that he seeks “economic castles protected by unbreachable ‘moats.’” He once bought shares of Guinness PLC because, as he put it, “It’s easier to break into the semiconductor industry than into the spirits industry.”
Buffett knows that wide-moat companies can parlay their moats into higher returns on capital. Indeed, you would be hard-pressed to find a better list of wide-moat companies than to simply look at Berkshire Hathaway’s list of long-term equity holdings.
In short, we live in a Darwinian economic world where companies compete to survive. Businesses without moats are vulnerable. And the last thing you want to do is own a vulnerable company in a weak economy.
Alexander Green is the chief investment strategist at InvestmentU.com. See more articles by Alexander here.