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Tutorial - Economic Moats
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Dilemma. Investors, that is, owners of business (that's you) face a challenge. It seems
that if a business discovers a way to make a boatload of money, other companies
quickly see this and invade their territory. All too soon those massive profits disappear
because of competition. What is to be done?
Economic Moats. Thanks to Warren Buffett we now know that there are businesses
that have found ways to protect themselves from competition. They have what he
refers to as Economic Moats. Wise investors choose companies with Economic Moats.
Why do I want to buy companies that have Economic Moats? Well, these
companies:
How do you identify a company with an Economic Moat? There are several
questions to ask that help identify a company with an Economic Moat:
So the first step is to look at the industry. There are some industries that just stink.
The auto industry is one fine example. Why? Competition. No one can get a
sustainable advantage. They eat each other's lunch and continue to oversupply the
marketplace. And if a company does generate profits - they must plow most of those
profits back into the factory to innovate for the next year's model so they can stay
ahead of the competition. Just look at the price of GM stock over 40 years. It really
never went anywhere. It was not uncommon for GM to borrow money some years just
to pay their dividend. And of course, GM now stands for Government Motors. This
industry stinks!
Are there some good industries? Well, how about the gum industry? Yep, think of
Wrigley. I'll bet you they're still using the same factory equipment to make Double Mint
Gum that they used 30 years ago -- maybe even 50 years ago. So they don't need to
plow their profits back into the plant to make Double Mint Gum. The formula has not
changed, nothing has changed. Grandpa gave you a stick of this stuff when you were
a kid and you want the exact same gum when you're a grandpa (and you'll give a stick
to your grandchild who will think of you when he's an adult and has a stick of Double
Mint Gum). The brand name and the formula MUST not change, so the cash
generated from selling this gum either goes to me, the investor, as a dividend, or it gets
plowed back into the company to create new products that will have another huge,
protected margin.
There are several types of Economic Moats to look for:
As you might imagine, companies with an Economic Moat are few and far between.
But they do exist and they're the ones in which I invest because they have a unique
barrier to competitive pressure which gives me confidence that their products will be
around a long time and will sell for stable, increasing prices. That results in fat, stable
margins, substantial returns on invested capital, and predictable future cash flows.
Companies with Economic Moats are real power-houses!
So, once we identify these companies with Economic Moats, are we ready to buy?
No. Not quite. Remember the old saying "buy low, sell high"? To learn how to "buy
low" - Click Here.
that if a business discovers a way to make a boatload of money, other companies
quickly see this and invade their territory. All too soon those massive profits disappear
because of competition. What is to be done?
Economic Moats. Thanks to Warren Buffett we now know that there are businesses
that have found ways to protect themselves from competition. They have what he
refers to as Economic Moats. Wise investors choose companies with Economic Moats.
Why do I want to buy companies that have Economic Moats? Well, these
companies:
- eat their competitors' lunch because they have an advantage that can't be beat,
- can increase their prices over time rather than decrease prices due to
competition, and - have reliable future cash flows which we can use to determine a fair purchase
price for the stock.
How do you identify a company with an Economic Moat? There are several
questions to ask that help identify a company with an Economic Moat:
- Is this company in a healthy industry?
- Will this industry likely remain healthy in the next 20 years?
- Does this company have some unique advantage over other companies in its
industry? - Will this company's existing products continue to be desirable in 20 years?
- Will the company need to continually plow a high percentage of its earnings into
R&D or factory upgrades, or can I keep the cash as a part-owner?
So the first step is to look at the industry. There are some industries that just stink.
The auto industry is one fine example. Why? Competition. No one can get a
sustainable advantage. They eat each other's lunch and continue to oversupply the
marketplace. And if a company does generate profits - they must plow most of those
profits back into the factory to innovate for the next year's model so they can stay
ahead of the competition. Just look at the price of GM stock over 40 years. It really
never went anywhere. It was not uncommon for GM to borrow money some years just
to pay their dividend. And of course, GM now stands for Government Motors. This
industry stinks!
Are there some good industries? Well, how about the gum industry? Yep, think of
Wrigley. I'll bet you they're still using the same factory equipment to make Double Mint
Gum that they used 30 years ago -- maybe even 50 years ago. So they don't need to
plow their profits back into the plant to make Double Mint Gum. The formula has not
changed, nothing has changed. Grandpa gave you a stick of this stuff when you were
a kid and you want the exact same gum when you're a grandpa (and you'll give a stick
to your grandchild who will think of you when he's an adult and has a stick of Double
Mint Gum). The brand name and the formula MUST not change, so the cash
generated from selling this gum either goes to me, the investor, as a dividend, or it gets
plowed back into the company to create new products that will have another huge,
protected margin.
There are several types of Economic Moats to look for:
- High Customer Switching Costs. Paychex, Inc. is a good example. Once
Paychex starts processing a small business' payroll (computing their payroll
taxes, worker's compensation, retirement-plan record keeping, etc.), it is not
economically advantageous for the client to switch to a competitor or hire and
train an employee to do the same things. So, Paychex can incrementally raise
prices each year.
- Economies of Scale/Low Cost Provider. Who can compete with Wal-mart?
Sears? Hah! K-mart? Hah, hah, hah! Wal-mart has enormous power over its
suppliers to get rock-bottom prices because they sell so much stuff. Nobody can
touch their prices.
- Intangible Assets. The brand name of Coca-Cola is powerful. Even though
people prefer the taste of Pepsi's cola in blind taste tests, there's some type of
"Pavlov's Dog" reaction to the label on the Coke can that has a powerful affect
on people. Other useful intangible assets include patents, special government
approvals, or unique geographic advantages.
- Network Effect. If you want to buy or sell something on-line you're going to use E-
Bay because that's the location with all the buyers and all the sellers.
Companies which can take advantage of the network effect were typically the first
to establish standard in a new market.
As you might imagine, companies with an Economic Moat are few and far between.
But they do exist and they're the ones in which I invest because they have a unique
barrier to competitive pressure which gives me confidence that their products will be
around a long time and will sell for stable, increasing prices. That results in fat, stable
margins, substantial returns on invested capital, and predictable future cash flows.
Companies with Economic Moats are real power-houses!
So, once we identify these companies with Economic Moats, are we ready to buy?
No. Not quite. Remember the old saying "buy low, sell high"? To learn how to "buy
low" - Click Here.
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| The advice contained within this website is general in nature, only for the use of FI Investments clients, and should not be relied upon without first consulting with FI Investments. |