A competitive edge that enhances a company’s appeal as an investment.
Have you ever wondered what Warren Buffett means when he says that he looks for businesses with wide economic moats? While it’s fun to imagine a company in a castle surrounded by alligator-infested waters, what Buffett actually means is that he looks for businesses that have strong competitive advantages. There are many different types.
Brand: Some people will only buy Apple computers, others will only drive Harleys, and yet others will only wear Nike sneakers. Be it through smart advertising, quality products, or the ultimate achievement -- teens think it’s cool -- once a brand develops a loyal customer base, competitors will have a hard time prying those folks away.
Quality: It didn’t take long for Google to become the king of search engines. Why? Its product was just that good. And as long as a company continues to deliver top-notch goods or services, a cult of happy buyers will usually continue to follow.
Pricing Power: Some businesses are large enough that they can under-price their competitors. Wal-Mart is an example. Others have a price advantage because they’re vertically integrated -- meaning that one company handles of all stages of making, selling, and distributing its products, versus farming out part of the job to someone else. There are many ways to build pricing power, and businesses that can consistently charge lower prices than their competitors stand a good chance at winning repeat customers.
Intellectual Property: For many businesses patents and trade secrets protect know-how that helps the business compete. Copyrights to the Disney characters are a major asset to the company. Old movies, TV programs, books or art prints can be major assets in some businesses. They too are protected by copyright law.
Competitive advantages are frequently cited by ultra-long-term investors such as David Gardner, who look for stocks they can hold for a decade or more. The greater a company's competitive edge, the more likely it is to keep cranking out those cash flows.
That said, several factors can threaten a company’s moat -- maybe the business is a leader in a collapsing industry (printed newspapers, anyone?), or perhaps a new company has come along with better ideas, faster execution, disruptive technology, and even lower prices. Even a wildly popular brand could suddenly fall out of fashion (poor Crocs). But whatever the reason, moats don’t necessarily last forever. They’re a very attractive quality in a business, but like everything else, they need to be monitored.
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