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CATEGORY Fundamental analysis

Be like Buffett: Understanding Economic Moat

December 19, 2016

It’s impossible not to take words of wisdom from Warren Buffett.

Whether it’s through his presentations to thousands of his investors, or just a quick interview, ignoring his advice could cost you dearly.

And, oftentimes, his investment advice is simple to understand.

For Buffett to invest in a company, he must fully understand the nuts and bolts of a company. It must be simple for him to understand,

That may help explain why his portfolio has more consumer related stocks than biotech or technology. He’s also looking for a healthy stream of earnings, as well as a stock that can be bought at a reasonable price.

However, one of his greatest metrics for identifying gems is his rule of identifying a company’s “economic moat.”

"A truly great business must have an enduring "moat" that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business "castle" that is earning high returns,” he notes, as quoted by Townhall Finance.

"Therefore a formidable barrier such as a company's being the low-cost producer or possessing a powerful world-wide brand is essential for sustained success. Business history is filled with "Roman Candles," companies whose moats proved illusory and were soon crossed."

If you have a strong “moat,” or a unique ability to maintain competitiveness, despite growing competition, the stronger you become as an entrepreneur, as a startup, or as an existing company owner. A strong “moat” doesn’t just refer to what Warren Buffett wants to see. It’s also a way to view your own operations for continued success.

In defining economic moat a bit better, here is a simple question.

If I handed you $50 billion and asked you to replicate Apple, Microsoft, even Starbucks, can you do it… successfully?

For most of us the answer is no. And that’s simply because those companies have a wide-reaching protective moat. And because they have such a moat, they can protect long-term profits and market share from other competitors trying to weigh in.

Understand moat, and you stand to increase your odds of longer-term success.

As Buffett has famously noted, in business, “I look for economic castles protected by unbreachable moats…”

For an entrepreneur, creating a moat involves a multi-step process of asking what the new mega-trends are, or what’s beginning to appear on radar, barriers to entry for new emerging moats, and an attractive market that can be improved upon, or by simply tapping into markets where there is unmet demand, for example.

In simple terms, forge ahead with new grounds where others wouldn’t dare.

Traits of a Powerful Moat

A moat is what allows a company to protect itself from its competition.

It allows a company to do what its competitors cannot do – like charge a 400% premium for coffee, as Starbucks can do… even though you can buy coffee for $2 at a local mom and pop.

Sony for example once had a stranglehold on the portable music business. But it lost that moat to Apple. It’s nearly impossible to name a music device that isn’t an iPad these days.

Blockbuster lost its moat to Netflix and RedBox.

When it comes to a successful moat:

There is a strong brand name

When you think of coffee, many of us think of Starbucks immediately. It has a powerful brand with incredibly loyal customers that pay more than a 300% premium for coffee. Coca-Cola is one of the most dominant names on the planet that can dominate its competition.

Strong brands drive sales, market values, and eventually shareholder value. It’s tough to penetrate a thick moat of a strong brand. If I handed you $100 billion, could you replicate Coca-Cola, Microsoft, Apple, or Starbucks? Probably not…

Switching Costs can be Too High

At t one time, about 70% of computers ran Windows. Thirty years after launch, Microsoft was generating $18 billion in revenue from Windows. It enjoyed that because of its moat, strengthened by switching costs.

The gains of using any other product are far outweighed by the “switching costs.” If I wanted to switch from Apple to Microsoft, for example, after years of loving my Mac, I would have to buy a new computer, new software programs, and spend the time to relearn everything I already knew with the Mac. In short, sometimes, it’s just not worth the hassle because the overall costs are too high.

There is network effect

Facebook and Twitter have a network effect that’s not easy to replicate. Even eBay has this effect, cornering the auction market online. Sellers and buyers use the site to network with millions of other buyers and sellers. Simply based on the network effect of eBay, it’s nearly impossible to penetrate that moat, or disrupt the revenue stream.

Lower-Cost Providers

Inspired by the success of a dime store he once owned, Sam Walton would open the first WalMart in 1962 in Rogers, Arkansas. Competitors thought the idea of offering lower prices and better value would never work. Eight years later, Walton began to expand outside of Arkansas. By 1970, 38 stores were opened with $44.2 million in sales.

By 1990, after a great deal of hard work and determination, the discount retailer would become the top retailer in the U.S. with $26 billion in sales. The company is now worth well over $223.5 billion, crushing most of its competitors with lower cost goods. The ability to offer good products at lower costs is why the company has become a multi-billion dollar retail behemoth. It can’t be touched.

It has Intangible Assets

There are some companies that have a powerful advantage over others because of intangible assets, including patents, licenses, and brand recognition. If a company’s product is protected with a patent, it’s tough to replicate. A pharmaceutical company can pay top dividends to investors thanks to patents on top-selling drugs, which can crush competitors. While such companies have a protective moat, the potential loss of patent protection on some drugs can make companies a bit nervous.

While the practice of identifying moat has made Warren Buffett and smart investors a great deal of money, such knowledge can also help in the development of a new entrepreneurial idea. Keep these things in mind as you develop your ideas.

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