Legendary investor, Warren Buffett recommends that investors try to find companies with moats — those features that allow a business to remain competitive, thereby protecting its profits and market share.
Perhaps the most obvious type of moat relates to size. The bigger a company is, the more it will be able to take advantage of economies of scale. It can produce more for less and set prices lower than rivals while still making a profit. Large companies are also less likely to run into trouble when economic conditions deteriorate.
Consider Royal Dutch Shell (LSE: RDSB). With a market cap of £178bn, the oil major is by far the biggest business listed on the London Stock Exchange. While its fortunes will always depend on factors it can’t control (like the price of oil), the sheer size of the business allows Shell to absorb the kind of shocks that would cripple many smaller companies. Even when Brent Crude plummeted to $28 last January, the company was able to cuts costs where necessary and preserve its much-prized dividend.
Brands are another form of moat. One example of a company having an enviable portfolio of ‘sticky’ labels would be £49bn cap consumer goods giant, Reckitt Benckiser (LSE: RB). Many shoppers wouldn’t dream of moving away from products such as Dettol, Cillit Bang and Air Wick, despite being aware that the differences between these and cheaper alternatives are fairly negligible. This gives earnings a degree of predictability, which also means that shares in the Slough-based business consistently trade on a price-to-earnings (P/E) ratio of at least 20.
British American Tobacco (LSE: BATS) — in addition to owning some of the industry’s best known brands — also benefits from a different kind of moat in the form of new legislation. The growing opposition to smoking now makes it highly unlikely that new companies will attempt to enter the market, thereby allowing British American to retain and build on its dominant position.
A declining industry? Perhaps, but one that could still generate significant returns for shareholders over the medium term. On a P/E of 20, the world’s biggest tobacco company (having recently agreed to buy its biggest rival Reynolds for £40bn) still warrants a closer look.
Don’t get too comfortable
While all of the above present as relatively safe investments, the fact that a company has a perceived advantage shouldn’t be taken for granted. In contrast to those protecting Shell, Reckitt Benckiser and British American Tobacco, some moats can be narrow and/or short term.
Apple is one of the most valuable companies in the world. Given the relentless progress of technology however, it must continue to innovate to avoid becoming the next Blackberry. ASOS may be a favourite online destination for millions of young people but, thanks to the fickle nature of fashion, this may not always be the case; even more so if talented members of its board (another moat) decide to leave. And as the process for switching accounts becomes easier and quicker, banks and utilities can no longer rely on having the same customers for life as they once did.
All this makes at least a degree of diversification vital when investing, even if your portfolio appears chock full of companies with economic moats. While this may reduce your returns over time, it’ll also allow you to sleep at night.
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Paul Summers has no position in any shares mentioned. The Motley Fool UK has recommended Reckitt Benckiser and Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.