Warren Buffett once said: “In business, I look for economic castles protected by unbreachable moats.” Since Mr. Buffett uttered those words, investors have become more interested in the concept of economic moats.
As it turns out, the concept of an economic moat is a proprietary data point of Morningstar, a leading resource for investment research. It refers to the likelihood that a company can keep its competitors at bay for an extended period. For investors, these companies provide stability and superior returns over the long term.
It therefore comes as no surprise that investors want to know more about economic moats so they can incorporate them into their investment analyses.
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A Primer on Economic Moats
Economic moats essentially speak to a company’s competitive advantage vis-à-vis the broader market and its main competitors. In the case of Morningstar’s analysis, researchers attempt to quantify a company’s strength by looking at its historical financial performance, as well as five important attributes:
- Network effect: The network effect reflects the company’s ability to increase adoption of its product or service. In this case, the value of a company increases as new and existing customers use its products or services. Larger networks have greater utility. A company like eBay (EBAY ) demonstrates a strong network effect because its value grows as more people conduct business on the platform.
- Intangible assets: It’s not all about dollars and cents; a loyal customer base is a powerful attribute of successful businesses. Companies with patents and popular brands cannot only charge higher prices, but also ensure that competitors do not duplicate their products. For intangible assets like brand loyalty, think Apple (AAPL ).
- Cost advantage: Meaningful economies of scale and strong operating and profitability ratios make a company more attractive from the perspective of investors. Companies with cost advantage have two benefits: they can either undercut competitors on price while earning similar profit or they can charge higher prices while earning even bigger margins. Walmart (WMT ) is a prime example.
- Switching costs: Companies with products and services that cannot be easily abandoned have a distinct advantage. Users avoid switching to competitors because the cost of doing so (money, time, opportunity cost, etc.) is very high. Microsoft’s (MSFT ) Excel package is a notable example as accountants often spend a great deal of time mastering the software.
- Efficient scale: Specialized industries that are served by one or a small number of companies are said to have an efficiency of scale. Some of these industries, such as energy, may have a natural monopoly if the cost of replicating the business is too high. A company like Xcel Energy (XEL ) is a notable example.
Click here to learn why Warren Buffett looks for wide economic moats.
The more of these attributes a company possesses, the more attractive they become from the perspective of value investors. However, not every competitive advantage is considered an economic moat. Here, it’s important to distinguish between a competitive advantage or narrow economic moat and a wide economic moat.
A competitive advantage, or a narrow economic moat, refers to any advantage that currently enables a company to earn stronger margins relative to its competitors. A wide economic moat, on the other hand, offers a sustainable competitive advantage over the long haul. For example, narrow moats exist in industries with increased competition, which limits companies’ pricing power. Consumer products (think General Mills (GIS ) and Kellogg (K )) and telecommunications (such as AT&T (T ) and Verizon (VZ )) are examples of industries with narrow economic moats.
Wider economic moats exist in industries such as technology, where brand power (intangible assets) and network effect are very large. This allows tech giants such as Apple (AAPL ) and Netflix (NFLX) to generate sustained growth and above-average returns over the long haul. Some retailing giants, such as Walmart, also enjoy wide economic moats because of their tremendous size and scale. In the case of Walmart, its size enables it to demand the lowest possible price from suppliers.
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The importance of economic moats cannot be overstated; without them, estimating future cash flows is next to impossible.
As a general rule, proponents of economic moats require a significant discount to liquidable assets if they are to invest in stocks without one of the five attributes mentioned above. Based on this rule, investors can eliminate most stocks they stumble upon when carrying out fundamental research. Using this strategy, economic moats can guide the entire investment process from searching to researching and all the way up to buying and selling stocks.
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The Bottom Line
Economic moats are essential for value investors. Without them, estimating cash flows is exceedingly difficult. A stock selection strategy that focuses on these attributes is more likely to succeed over the long term.
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