Why Economic Moats Are Important to Investing

Source: Thinkstock

Source: Thinkstock

One of the best investment strategies is to focus on companies that have what is known as a wide economic moat. A real life moat is constructed around a property in order to protect it and its owners from invaders. In the analogy at hand, these invaders are competing companies. So a company with a wide economic moat is well protected from potential competitors.

Moats can appear in many different forms. There are three that are especially important to successful investing. The first is the capital intensiveness of a business. If you invest in a business that is fully operational but which would require a lot of capital in order to replicate, then this business has a wide economic moat. Take, for instance, the rail transport industry and compare it to the trucking industry. Anybody with a few hundred thousand dollars can buy a couple of trucks, advertise on Craigslist, and compete, at least on a small scale, with large trucking companies such as Swift Transportation (NYSE:SWFT). However this isn’t the case for the rail transport industry.

It would take hundreds of millions of dollars, if not more, in order to build the infrastructure necessary to compete with the likes of Union Pacific (NYSE:UNP) and CSX (NYSE:CSX). Therefore there are only a handful of rail transport companies, and we can predict that these same companies will continue to control the industry for years to come. Similar moats can be found in other industries where companies need a lot of capital intensive infrastructure in order to compete. Two such industries include telecommunications (E.G. AT&T (NYSE:T), Verizon (NYSE:VZ), Sprint (NYSE:S), and the cashless payment industry “e.g. Visa (NYSE:V), Mastercard (NYSE:MA), American Express (NYSE:AXP), eBay (NASDAQ:EBAY), and so on.”

The second sort of moat comes in the form of brand recognition. Consumers and businesses are going to do business with companies they trust, and companies with well established brands are going to have economic moats. For instance Coca Cola (NYSE:KO) can sell its products pretty much anywhere it wants to, and because consumers recognize the brand they will purchase the product. But if I were to start my own cola company and call it “Ben’s Cola” I would have a hard time selling it if it sits next to “Coke” products on the grocery store shelf. I would have to do a lot of marketing and prove to consumers that they should purchase my product over the pre-established products. Since it is so easy for Coca Cola to sell its products its business is far less risky than companies with weaker brands, and they should perform better in the long run.

The third sort of moat comes with some sort of unique knowledge. This usually manifests in a company’s patent portfolio.  Companies that have patented products have de facto monopolies on particular products, and this means that we can count on consumers buying their products. For instance drug companies that own patents on drugs are extremely difficult to compete with because in order to do so you can’t just replicate their products without breaking the law. If you wanted to compete with a drug company you would have to come up with a new drug that achieves the same end but which doesn’t infringe on the company’s patent. This is very costly.

Of course the economic moat becomes “wider” in cases where two or three of these moat-forms come into play. Take Pfizer’s (NYSE:PFE) Viagra as an example. This patent has expired, but before it did this product had all three moat characteristics.  First, competing with Viagra is extremely capital intensive. Only a multi-billion dollar drug company could invest in such a product.  Second, Viagra is a well-known brand. Everybody reading this knows what Viagra does, and men reading this know that if they suffer from impotence they should get Viagra. Third, Viagra was protected by a patent (it isn’t any more). This trifecta made the Viagra business a phenomenal one.

Investors who consider these three moat qualities when evaluating the products of potential investments should do extremely well.  While the companies mentioned in this article are going to see their sales and profits decline if the economy weakens, they are among the strongest companies in the world. The reason for this is that their businesses are protected by economic moats.

Disclosure: Ben Kramer-Miller is long Visa and CSX.

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