An economic moat, as described by Warren Buffett, refers to the protection a company has against its competition. This is important, because without an economic moat competitors can just swoop in and copy a company’s methods to success. Here as three reasons why the companies you invest in should have moats.
High margins attract competition
When a business has high margins and is therefore highly profitable, it’s only natural that others will look at the business with envious eyes and want a piece of the pie for themselves. You want your chosen company to invest to have a moat to protect it from those predators looking to eat into its market share.
Consider Apple, the world’s most valuable company. It has high margins, so how does it protect itself? The Apple ecosystem. Everything is geared towards making the customers’ lives easier, so that they do not want to switch to any competitors. Apple has a high retention rate – once people start using Apple products, they rarely wish to change to any other phone or laptop manufacturer.
This is how the business has developed a huge fanbase, and an almost cult-like status.
Low margins need defending too
Not all high margin businesses are highly profitable companies, and not all low margin businesses are highly unprofitable companies either.
Look at Ryanair (LSE: RYA), the airline that’s so cheap the founder has claimed he would get rid of the airline seats if he could. He has a relentless focus on driving down prices, which is of course the company’s moat.
It’s hard to damage Ryanair when most of its competition has higher operating costs per seat than Ryanair charges in revenue. Despite the low margins, Ryanair has been able to carve out a growing aviation empire by hammering down on its core competencies: achieving low cost through superior volumes and leveraging those volumes for attractive supplier agreements.
The larger the volume of passengers and business it brings, the more attractive the supplier agreements become.
No moat leaves your stock open to attack
When a company doesn’t have a moat, then it is susceptible to being copied. This happened to UK window seller Safe Style (LSE:SFE) which had high margins and managed to grow across the UK. Unfortunately, there was no moat in fitting and selling windows and competitors soon appeared and drove the price right down, eroding those margins.
The best companies on the stock market often have wide and discernible moats. These can be created through intellectual property or product ecosystem, or the nature of the business itself through volume. If your portfolio is full of stocks that have no real moats, then perhaps it’s time to have a rethink about your ownership in them.
Michael Taylor holds no position in any of the stocks mentioned. The Motley Fool UK owns shares of and has recommended Apple. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.