After teaming up with Charlie Munger, Warren Buffett often talked about the importance of an economic moat for companies that he would consider investing in. Just as a moat around a medieval castle kept the castle safe from intruders, an economic moat around a company keeps it safe from competitors and other profit-draining forces.
During the credit boom, some said Warren Buffett had lost his search for economic moats. However, after the promoter of Berkshire Hathaway (BRK.A) clinched a sizeable investment in Goldman Sachs (GS) in 2008, Wall Street"s strongest name then, investors knew what the master had been waiting for. Having clinched several successful deals last year in the financial sector in the midst of a subprime catastrophe that saw the demise of Lehman Brothers Inc., Buffett�s Berkshire now seems to be keen to shift its asset allocation to more sustainable businesses.
Although Berkshire Hathaway, which disclosed its December 2008 holdings this week, is not worried about its portfolio size shrinking by 25% in the fourth quarter of 2008, it certainly is adapting to changes. Little wonder then that the firm has reduced its exposure to ratings agency Moody"s (MCO) by 25% and instead bought shares in a diversified electric generation company NRG Energy (NRG) and a water treatment company Nalco Holding (NLC).
While the former is a Fortune 500 company with approximately 24,000 megawatts (MW) of power generation capacity, the latter is a global integrated water treatment solution provider. It is certainly not difficult to figure out what kind of �moats� the legendry investor is looking for in such uncertain times.
Do you know the most important thing Warren Buffett looks for when evaluating a company?
It"s not a debt-free balance sheet, a history of strong free cash flow generation, or a strong corporate culture. It"s not even an undervalued stock price -- although that is certainly a hallmark of most Buffett buys.
Nope, the first thing Buffett looks for is an economic moat -- the bigger the better.
The key to the castle Buffett himself coined the term "economic moat." It refers to a business" competitive advantages that keep other companies at bay. Finding companies with significant, sustainable competitive advantages has been key to Buffett"s phenomenal performance. As the Oracle of Omaha told Fortune magazine:
The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company, and above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.
Emphasis on "sustainable" Astute readers (and fans of italics) will notice that I placed special emphasis on the sustainability of a company"s competitive advantage. I wanted to draw your attention to that point because in business, most competitive advantages are short-lived.
Just look at IBM. In the early 1980s, the company was largely responsible for popularizing the personal computer. However, competitive pressure made the PC a commodity item, while up-and-coming companies unveiled famously efficient business models that further compressed IBM"s profit margins.
As a result, IBM"s PC division shifted from a growth driver to a value destroyer. IBM ultimately sold its struggling PC business to Lenovo in 2004 for a modest $1.75 billion.
Fame is fleeting As IBM proved, cutting-edge technology may be cool, but it"s not a source of sustainable competitive advantage.
And according to hedge fund manager and former Morningstar equities strategist Mark Sellers, the same can be said of a good management team, a catchy advertising campaign, or a hot fashion trend. These attributes may produce temporary advantages, but they are likely to erode over time, or be duplicated by competitors.
As far as Sellers is concerned, there are only four sources (PDF file) of sustainable competitive advantage -- the key to a true economic moat:
1. Economies of scale
This is a fancy term that economists love to throw around. Basically, it means that bigger companies can offer products at a lower cost than smaller ones.
Target (NYSE: TGT) is a good example of economies of scale in action. Because of its mammoth size, Target wields tremendous bargaining power over its suppliers, and it can spread its operational costs across a wide store base. The company can thus undercut its competitors on price while still turning a tidy profit.
2. The network effect
The network effect occurs when the value of a service increases in direct proportion to the number of people using it. For example, eBay becomes more useful as the pool of buyers and sellers grows -- although it also becomes increasingly difficult to snag that vintage mint-condition Rolling Stones 1972 U.S. tour poster.
Network effects are also largely responsible for the success of credit card companies such as Discover Financial Services (NYSE: DFS). After all, the more merchants that accept these cards, the more likely users are to carry them. Meanwhile, the more users that carry them, the more likely merchants are to accept them!
At The Motley Fool, we also benefit from network effects. The more members join our Stock Advisor community, the more powerful our discussion board community becomes.
3. Intellectual property rights
Companies such as GlaxoSmithKline (NYSE: GSK) and Genentech (NYSE: DNA) have been long-term market-beaters, in large part because of the strength of their patent portfolios. These companies have proved to be adept at transforming the money they"ve spent on research and development into profitable products.
Truth be told, the beverages produced by Hansen Natural (Nasdaq: HANS) and Starbucks (Nasdaq: SBUX) are pretty similar to those offered by competitors. But consumers continue to choose these companies" concoctions over cheaper alternatives due to the power of the companies" brands.
4. High switching costs You know a company has a wide moat when its customers stick around year after year -- even if they hate the product! For years, users have complained about Microsoft"s software, yet most of the wired world runs on Microsoft products.
The reason is simple: It would be an enormous effort to retrain employees and transfer files to a new format. And besides, everyone else uses Microsoft"s software, too. Talk about a network effect!
Moat money Finding a company with a wide and sustainable moat is a good start, but that"s not enough to produce long-term market-beating returns. A bargain price is always imperative, as are some things Fool co-founders David and Tom Gardner search for in their Motley Fool Stock Advisor service: wide-moat companies with strong balance sheets, dedicated and shareholder-friendly management, and wide market opportunities.
