[Updated on May 31, 2018]
In business, I look for economic castles protected by unbreachable moats — Warren Buffett
Warren Buffett is arguably the most famous investor of all time. He is a legend in the investment community because he slowly turned a failing textile company into one of the biggest industrial conglomerates in the world. Buffett is widely considered to have coined the term “economic moat,” and he uses the phrase frequently when describing his investment process.
Buffett likens the term economic moat to a castle, whereby a large moat outside the castle can help defend against invaders. Basically, the term economic moat describes a margin of safety inherent in a company’s business model or technology, which helps prevent a competitor firm from easily stealing market share. As a noted value investor, Buffett insists on finding companies with wide economic moats before he will invest in them.
Dividend.com will discuss why Buffett feels a wide economic moat is so important, and an exchange-traded fund that follows his philosophy.
The Merits of Moats
Throughout his investing career, one can simply look at some of Warren Buffett’s biggest investments and easily see the economic moat philosophy put into practice. For example, Buffett’s Berkshire Hathaway (BRK-B ) owned 400 million shares of consumer goods giant Coca-Cola (KO ) as of its last reporting with the SEC on December 31, 2017. That is a massive investment, worth more than $16 billion, and makes Buffett’s Berkshire Hathaway the company’s largest investor.
Many analysts have come to criticize Buffett’s massive investment in Coca-Cola, as consumers are paying much more attention to what they are eating and drinking than ever before. Soda sales have declined in the U.S. for the past decade, as consumers are turning away from sugary, high-calorie beverages in favor of healthier alternatives like bottled water and tea.
But Coca-Cola has a wide economic moat, which means that it has several competitive advantages that defend the company against competing firms taking its market share. First is Coca-Cola’s formula. This is a patented formula for its syrup, which is kept in a locked vault underneath Coca-Cola’s headquarters in Atlanta, Georgia. There is no other company on earth that can exactly replicate Coca-Cola’s formula. The company does not have to worry about a competitor swooping in with an identical product and stealing its market share. Many have tried, but they have all failed.
The concept of an economic moat is closely associated with another key Buffett philosophy: margin of safety. A margin of safety is a method of protecting against downside risk in a stock. Buffett believes margins of safety are important when selecting investments – and a wide economic moat is one such margin of safety.
As a result, in order to identify such businesses that benefit from wide economic moats, the investor must determine whether a company has an unbreakable line of defense. Investors should avoid companies that manufacture goods or services that can be easily replicated. If that is the case, it is only a matter of time before a rival company steps in and steals its business.
In addition, an investor may want to look for a company that pays dividends to shareholders. In Buffett’s example, Berkshire Hathaway’s massive investment in Coca-Cola nets the firm approximately $592 million in annual dividends. A dividend payout is a valuable margin of safety, along with an economic moat, as a dividend payout provides downside protection and adds to an investor’s total return.
One ETN That Follows Buffett's Wide-Moat Strategy
For investors interested in following Buffett’s strategy, there is an exchange-traded note, or ETN, that seeks to replicate the economic moat philosophy. It is called the Morningstar Wide Moat Focus ETN (WMW). The fund’s inception date was October 2007. Since then, it has attempted to follow Buffett’s strategy of selecting stocks with wide economic moats.
This year, the fund has lost approximately 0.67% compared to the S&P 500, which increased marginally by 1% during the same period. The fund carries a 0.75% annual expense ratio and does not provide a dividend yield. The fund holds 100% equities and is categorized as a large-blend fund, meaning it holds primarily large-cap stocks across a wide range of market sectors. The fund invests in approximately 52 equities that qualify as wide-moat firms. Among the WMW fund’s top 10 holdings are Twenty-First Century Fox (FOXA ), Amazon (AMZN ), Salesforce (CRM ), Merck (MRK ) and Lowe’s (LOW ).
Among the sectors WMW invests in, the fund is relatively concentrated. Three specific sectors – healthcare, consumer discretionary and information technology – collectively comprise two-thirds of the total portfolio.
The Bottom Line
Warren Buffett built himself and Berkshire Hathaway shareholders a fortune over the years by buying stock in companies that have wide economic moats. Buffett believes one of the biggest dangers facing individual companies is the threat of unforeseen competition. This strategy has clearly worked well for Berkshire, which has produced outsized returns over many decades.
The WMW exchange-traded note is an easy, effective way for an investor to replicate Buffett’s wide-moat strategy. It invests in companies that Buffett likes – which are those that have competitive advantages including strong brands, long-tenured management teams, defensive business models and products that are not easily replicated.