The ideal business has a deep, wide moat stuffed full of alligators.
Whenever you buy a share you are purchasing a stake in that company's future. For a company to remain profitable its customers must continue to purchase the company's goods and services for the foreseeable future.
One way in which a company can secure its future profits is by producing goods and services which are highly resistant to competition. Any competitors who produce or are thinking of producing a comparable product should thus be put at disadvantage because of the company's sustainable competitive advantage or as Warren Buffett calls it, a "moat."
An example of an extremely strong moat is having a product with a very well-known brand name, perhaps the best example of this is Coca-Cola. Buffett has remarked that companies, in order to protect their markets and thus their long-term profitability, should concentrate on both widening and deepening their moats wherever possible by adding "alligators."
A company with a strong moat can continue to earn extra profits far into the future, so providing investors with greater security for their investment. The trick for an investor is to spot companies with strong moats.
Barriers and Brands
A moat takes one of three forms; a barrier to entry, branding or economies of scale.
A "barrier to entry" is anything that makes it difficult for a competitor to enter a firm's market. Two examples are where a market is a natural monopoly such as the water utilities or if you become the dominant supplier in a market where network effects exist such as Microsoft has created thanks to its Windows operating system.
"Sunken costs" are the money that has been spent by a firm that is already in a market and which cannot be recovered if the firm stops operating. These "sunken costs" deter other firms from entering that market -- the classic sunken cost being a dry dock which is completely useless for any other task.
Despite its claims to favour free trade, the European Union routinely creates barriers to entry because EC regulations can make it difficult for new firms to compete in an existing market. This protects incumbent firms from competition.
"Branding" is essentially having strong brand names and a good reputation for your products, but it also includes patents, copyright and trademarks. People like their brand named goods and services and it can take a competitor a lot of effort to persuade them to switch to their alternative products. Advertising forms a vital part in creating and maintaining a strong brand name as well as stopping consumers from switching to alternative brands. A really strong brand can create a barrier to entry; Buffett once said that "if you gave me $100 billion and said take away the soft-drink leadership of Coca-Cola, I'd give it back to you" (because it was impossible). But a weak brand cannot create a moat.
Beer and Monopolies
Patents give a firm a temporary monopoly over a product that stops most forms of competition as other firms cannot legally produce an equivalent product. Pharmaceutical companies such AstraZeneca (LSE: AZN) and GlaxoSmithKline (LSE: GSK) have relatively low price-earnings ratios mostly because the lifespan of their existing drug patents is quite short (a pharmaceutical company with patents with an infinite lifespan would be a phenomenal investment).
Trademarks are similar to brands in that they tell consumers what to expect from the product. The oldest trademark thought to have been continuous use is the German beer Löwenbräu, which dates back to 1383; in comparison the oldest registered British trademark is the Red Triangle logo used by Bass Breweries which is a relative youngster having been registered in 1876. So if your better half asks why you've been spending time down the pub then if nothing else this article has given you the excuse that you've been doing some essential investment research into brands and trademarks!
The third moat, "economies of scale", exists where a firm's average production costs begin to fall merely because the firm has grown to a sufficient size. This means that the firm can then sell at lower prices than its competitors yet retain the same profit margin. Sufficiently large economies of scale will enable a firm to create a monopoly. Car manufacturing is a business which has large economies of scale but as we've seen this year for some American manufacturers these became "diseconomies of scale" that increased their production costs and have forced them into bankruptcy.
Firms with moats
The British food retailing sector is dominated by the big four supermarkets, Tesco (LSE: TSCO), Sainsbury (J) (LSE: SBRY), Morrison (Wm) (LSE: MRW) and ASDA. Each is a brand name in its own right, all also benefit from economies of scale that lower their distribution costs and their massive purchasing power drives suppliers' prices down. Happily for them, local and national planning restrictions create a major barrier to entry which prevents new competitors from entering many local markets.
Manufacturers of consumer products such as Diageo (LSE: DGE) and Unilever (LSE: ULVR) will rely on strong brand names and advertising to create a variety of individual product moats.
However, a moat cannot protect a business forever due to changing technologies. One such example is ITV (LSE: ITV) which used to have a moat thanks to its monopoly over TV advertising but this has been smashed by multi-channel TV, hammering ITV's profits.
So when you're looking at a company, consider whether it has any moats. If not, maybe a competitor with a half-decent moat might be a better alternative investment.
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> Tony owns shares in AstraZeneca, GlazoSmithKline and Sainsbury.
