One of Warren Buffett’s enduring legacies will be the concept of finding companies with an “economic moat”. In his 2007 letter to Berkshire Hathaway shareholders, Buffett explains that “competitors will repeatedly assault any business ‘castle’ that is earning higher returns,” so “a truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital.”
Although Buffett will be best remembered for the idea, he’s not the only one using it. Billionaire investor Kenneth Fisher looks for companies with an “unfair advantage” while Joel Greenblatt, author of The Little Book that Beats the Market, looks for a “special advantage.” Whatever they call it, all three investor are focused on companies that dominate their industries and have a competitive advantage. What does this advantage actually look like?
Moats are usually found in large companies with a broad customer base. The first and most obvious type of moat comes with monopolies and limited markets. In Ontario, the LCBO is a good example of a moat, controlling the sale of alcohol in the province. The second type of moat is found in companies with patents and product licenses, like Apple, which own exclusive rights to produce their products. Low-cost is a third type of moat, belonging to companies like Walmart that can make or sell a product for less than a competitor. The fourth type of moat belongs to companies like Facebook who use the network effect. Their service becomes more valuable the more people adopt it. The final type of moat develops when customers have no reason to adopt a competing product. Insurance policies and other long-run standardized services are a good example.
Most people think moats only protect against external threats, but they also allow for inevitable management mis-steps. In his 1996 letter, Buffett noted that “in contrast to this have-to-be-smart-every-day business, there is what I call the have-to-be-smart-once business. For example, if you were smart enough to buy a network TV station very early in the game, you could put in a shiftless and backward nephew to run things, and the business would still do well for decades.” No matter how wide the moat, even great companies will be challenged in economic downturns. However, a company with a deep moat is more likely to produce consistent cash flow and return to growth when conditions improve.
The toughest part of finding a moat is that it can seem very subjective. Luckily, moats often translate into items you can find in financial statements. For example, Buffett and Greenblatt identify high return on equity (+15% per year) as a sign of competitive advantage, whereas Fisher sees high profit margins (+5% over three years) as a sign of durability. These characteristics can be easily built into a rules-based approach like the Growth Portfolio.
Ben Kizemchuk is a Portfolio Manager & Investment Advisor with Altus Securities Inc. in Toronto. He offers financial planning and investment management for high net worth Canadian investors. Ben focuses on high quality investments, the Growth and Income Portfolios, low risk investing, and reducing tax.