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Moat Matters When it Comes to Dividends

What makes a great dividend stock? For many investors, the answer would likely be steadily rising cash flows & earnings, cheap levels of financial leverage and a product or service that everyone wants over the long term. All of these items are correct—without them, a stock’s dividend is as good as dead. If there are not enough buyers for the firm’s products, cash flows suffer. Too much debt? There won’t be enough profits to go back to investors. Zero earnings? Same story.

But how does a company get into this position? The answer is that there is a “wide moat.”

For investors, the key to finding great long term dividends is by selecting firms that have huge so-called moats.

Not Just For Castles

The term “moat” brings to mind medieval castles and protective knights. Back then, as a dragon or invading horde would approach, the moat would stop them in their tracks before they even got to the front door.

In business, a wide moat is essentially the same thing. A firm is said to have a wide moat when it has significant competitive advantages over its rivals—this can include everything from owning a patent on a new cancer drug or trade-secrets on a touch-screen technology to being the largest supplier of a certain kind of commodity or owning a large swath of the electrical grid. These are items that are hard or impossible to replicate. It’s pretty difficult to add a competing set of high-voltage transmissions right next to one that’s already been built.

The idea is that this moat keeps rivals out of the business and reduces completion. Huge economies of scale to high-switching costs for consumers all help to dig the moat wider and deeper. The larger the moat, the larger the competitive advantage is for the underlying company. Having few or no competitors basically allows a wide-moated company to continually generate high levels of profit and cash flows. If you think about diabetics and insulin, a patient is pretty much stuck using the medicine for the rest of his life and there are only a handful of firms (for example, Novo Nordisk (NVO )) that produce it.

The beauty is that a real wide/deep moat and competitive advantage generally can’t be destroyed by management. This is why Warren Buffett, Peter Lynch and other famous value investors pretty much only choose to invest in wide-moated firms.

Great for Dividends

The real reason behind all of this moat talk is how a wide moat comes back to investors. The bottom line is that firms with wide moats that use them to their advantage produce better earnings and cash flows—their stronger fundamentals and increased financial flexibility equate directly to increased dividends. There’s really no other way to generate strongly increasing dividends over time. As all those patent royalties, trade secrets and sales due to necessity of product come trickling back in, wide-moated firms “feel” them and that leads to outperformance on both dividend and total return fronts.

According to Morningstar, its “Wide-Moat Index”, which is made up of wide moat stocks trading for attractive prices (the kind that Warren Buffett likes), has managed to outperform the S&P 500 by an average of 6% a year since 2002—and six percent is nothing to sneeze at.

As for dividends themselves, the various ‘aristocrats’, ‘kings’ and ‘achievers’ lists of stocks with long histories of dividend increases and payouts are just littered with wide-moated firms. It highlights the concept of competitive advantage perfectly. Firms on these lists like Coca-Cola (KO ), Wal-Mart (WMT ), and Honeywell (HON ) all have big time advantages (secret recipes, economies of scale, etc.) that have helped them power their dividends over the decades. In fact, a wide moat is perhaps the only way to really get on these lists of dividend champions—you can only fake it for so long.

Digging A Trench

With wide moats being the biggest determinate of successful dividend growth and returns, income seekers may want to throw away any stock that doesn’t have one. A high yield is useless over the longer term if there is nothing backing it up.

And while the concept of a moat can be in the eye-of-the-bolder, most investors should be able to figure out just how “moat-inclined” their stock is. To start, investors can look at Michael E. Porter’s “Porter’s 5 Forces” model which analyzes five different competitive forces that shape every industry and firm—basically, it quantifies the concept of the moat. If your stock has one or more of these traits, then it’s safe to say it has a wide moat. The deepness comes from just how big an advantage is. Combining this with the previously mentioned dividend champion lists can also serve as a great starting point for finding wide-moat stocks.

Finally, if that doesn’t work: The Market Vectors Morningstar Wide Moat ETF (MOAT ) tracks the previously mentioned outperforming index.

The Bottom Line

A wide moat could be the biggest determining factor when it comes to dividends and total return outperformance. Finding those stocks with huge competitive advantages is key for investors looking to build wealth over the long term. Investors should follow Warren Buffett’s lead into these sorts of stocks.