When he buys a stock, Warren Buffett places more emphasis on one
factor above almost any other.
he has mentioned this single trait 20 times in his annual
. He calls it "essential for sustained success."
However, you won't find it listed on a company'sbalance sheet .
Its value doesn't rise and fall with themarket . And even if a
company reports greatearnings , the worth of this one advantage
still can't be calculated.
But that doesn't keep it from being a company's most valuable
Take the nastybear market of 2008 and 2009. From its peak to
trough, the S&P lost more than 55%. Noinvestment completely
avoided the downfall.
Well, almost no investment. Of the 500 stocks in the S&P,
only nine made money during that period.
Of those nine stocks, six of them (two-thirds) had this
But this advantage also helps these stocks beat the market in
uptrends, too. After all, Buffett has made billions thanks to
companies with this trait.
So what single advantage can capture the attention of Warren
Buffett... help a stock beat the market in an uptrend... and help
it fall less in a downtrend?
That advantage is a term originally popularized by Buffett
himself -- an
economic moat .
As Buffett puts it...
"A truly great business must have an enduring "moat"
that protects excellent returns on invested capital. The
dynamics ofcapitalism guarantee that competitors will
repeatedly assault any business "castle" that is earning
"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."
Warren Buffett, 2007 Berkshire Hathaway Shareholder
Economic moats protect a business from competition. That helps
the company with a moat earn unusually high profits.
Let me give you an example...
incredible story. In the 1970s, Paul Allen and Bill Gates created
the company, reportedly earning $1 million within their first year
That's where Microsoft's "moat" began. But it was the
introduction of the Windows operating system in 1985 that turned
its moat into one of the widest in history.
Approximately 70% of computers run a form of Windows right now.
Microsoft generated $18 billion in revenue from Windows in fiscal
2012 -- nearly 30 years after it was first introduced.
But how -- especially in an industry like technology, which
changes so fast -- has Microsoft been able to stay on top of its
Few people "love" Windows the same way that they seem to "love"
their iPhone... or their favorite drink at
. Yet billions of people continue to use the product day after day,
year after year.
That's because Microsoft -- and Windows in particular -- enjoys
a huge economic moat due to high switching costs.
High switching costsmean that the benefits gained from using
another product are outweighed by the "costs" of switching. If I
wanted to switch to another operating system, I would have to buy
the new operating system, and I'd also have to spend time learning
how to use it.
And that's not to mention that many software programs are built
to run only on Windows, creating another hurdle to switching.
That moat has made Microsoft's founders, Bill Gates and Paul
Allen, billionaires several times over.
But investing in economic moats can be a tricky thing?
As I said, moats aren't listed on a balance sheet orincome
statement . And there is no definitive list of what constitutes a
moat and what does not.
But while there isn't an exact list of moats, the most common
ones are easy tospot ...
-- A company that can provide the lowest price for the same product
can essentially shut its competitors out of a market. This is the
growth over the past several decades.
High Switching Costs
-- I explained how Microsoft has built a moat around its business
thanks to high switching costs. These costs keep customers loyal to
a product, even if better alternatives exist.
The Network Effect
-- How has
cornered the market in online auctions? Sellers want to list their
products on the site because of the huge number of buyers that shop
there. And buyers visit the site to find the most options from
sellers. Because of its vast network of users, no other auction
site rivals eBay's popularity.
Strong Brand Name
is one of the most dominant companies on the planet. Much of its
advantage comes from its powerful brand name. That's why even
though there are literally hundreds of substitutes, Coke is able to
dominate its competition.
-- Pharmaceutical companies have been able to pay their investors
billions of dollars in dividends thanks to theirpatents on drugs,
which shut out competition. Patents and other intangible assets
(like trademarks) can protect a company from direct
Risks to Consider:
Now, investing in moats is no guarantee that a stock will beat
the market. Plenty of other factors come into play. But if the
world's greatest investor has made billions of dollars investing in
"wide-moat" companies, don't you think you should too?
Action to Take -->
That's why economic moats are one of the key traits I looked for
when making my list of
The Top 10 Stocks For 2013
-- Paul Tracy
In the latest edition of my annual report , you'll find one
"wide-moat" company that has raised its dividend 463%
since 2004. Another dominates its market... has increased dividend
payments 85% since 2008... and has returned 117% since it went
public just over four years ago. You can learn more about these 10
stocks, including several names and ticker symbols here.
Paul Tracy does not personally hold positions in any securities
mentioned in this article. StreetAuthority LLC owns shares of SBUX
in one or more of its "real money" portfolios.