Economic moats checklist

“A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital.” – Warren Buffett

“A moat is a deep, broad ditch, either dry or filled with water, that surrounds a castle, fortification, building or town, historically to provide it with a preliminary line of defence.” – Wikipedia.

Legendary investor Warren Buffett coined the  term “moat” in finance.  A company needs a moat to protect its profitability and to fence itself against competitors.

If you’re an investor looking for the stock of a company that has an economic moat, remember that  Warren Buffett actually went one step further by saying  that the moat has to be one that is enduring.

“A truly great business must have an enduring ‘moat’ that protects excellent returns on invested capital,”  Mr Buffett said in his letter to Berkshire shareholders (February 2008) for Year 2007.

“The dynamics of capitalism guarantee that competitors will repeatedly assault any business ‘castle’ that is earning high returns. Therefore a formidable barrier such as a company’s being the low-cost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with ‘Roman Candles,’ companies whose moats proved illusory and were soon crossed.”

So what industries does Mr Buffet rule out then?

“Our criterion of ‘enduring’ causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s ‘creative destruction’ is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.

“Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.

“But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.”

In Pat Dorsey’s book, The Five Rules For Successful Stock Investing, Pat Dorsey listed four steps to help analyze a company’s economic moat:

(1) Evaluate the firm’s historical profitability. The true litmus test of whether a firm has built an economic moat around itself is to see whether it has been able to generate a solid return on its assets and on shareholders’ equity.

(2) If the firm has solid returns on capital and consistent profitability, assess the sources of the firm’s profits. Ask questions like why the company is able to keep competitors at bay and what keeps competitors from stealing its profits.

(3) Estimate how long a firm will be able to hold off competitors, which is the company’s competitive advantage period. Some companies are able to fend off competitors for a few years while some are able to do it for decades.

(4) Analyze the industry’s competitive structure. Ask whether the firm is in an attractive industry with many profitable firms or a hypercompetitive one in which the players struggle just to stay afloat.

Recommended reading:

(1) Berkshire Hathaway Letters to Shareholders, 1965-2013

(2) The Five Rules for Successful Stock Investing: Morningstar’s Guide to Building Wealth and Winning in the Market