A Look at Economic Moats - Part 1

By Chris Gallant | November 16, 2005 AAA

At the Investopedia Advisor we believe that there are a number of criteria that separate great companies from the pack. In the case of larger more well established companies (these types of companies are added to our Core Holdings model portfolio) we feel that one very important characteristic is the company's level of sustainable competitive advantage. Sounds pretty obvious right? Not always...

So when examining the large cap field, what is it that separates companies that thrive for decades from the ones the flounder for years, ultimately disappointing investors (General Motors (GM) we are looking at you right now)?

We believe that part of the answer lies in what is referred to as a company's "economic moat" - a phrase popularized by investing legend Warren Buffett. In this piece we'll introduce to you the concept and explain why it is so important to us when looking for companies to add to our Core Holdings portfolio.

What is an Economic Moat?
"Economic moat" refers to the character and longevity of a corporation's competitive advantages over similar companies competing in the same industry. Remembering back to Economics 101 we know that if Company A is producing excess profits competitors (Companies B, C and D) will soon take note and attempt to enter the industry and do the same. As capital flows into the industry, unless Company A has advantages over its competitors, the new competition will erode their profits.

An economic moat, then, can be said to be the barrier which protects a firm and its profits from competing firms. Just like a typical medieval castle, the moat serves to protect those inside the fortress (and their riches) from outsiders. Without a wide economic moat, there is little to prevent competitors from stealing market share (and thus profits).

However, not all competitive advantages are created equal. Some companies appear to posses an economic moat, that is until they disappear into thin air, others are sustained for decades - the trick is determining the difference. Commonly investors mistake a technological advancement with an economic moat. Take for example Palm Inc's (PALM) Palm Pilot product line. For a while PALM enjoyed a considerable advantage in its market, that is until competitors realized how lucrative it was and entered with a vengeance. Once names like Sony (SNE), Hewlett Packard (HPQ), Research in Motion (RIM), Nokia (NOK), and even Microsoft (MSFT) stepped in, PALM's success was all but over and its share price dropped precipitously.

Therein lies a great example of a company without an economic moat. If competitors are easily able to compete with little to no barriers to entry, a moat does not exist.

In contrast, other companies enjoy wide economic moats for long periods of time, enjoying large profits for many years. A good example of a sustainable competitive advantage can be seen in the case of Wal-Mart (WMT). Wal-Mart's historic rise to a massive market capitalization from its modest beginnings was largely a result of their aggressive cost-controls and subsequent low-price advantage over competing retail outlets.

Once Wal-Mart grew to be a mega-cap company, they enjoyed further cost advantages afforded by their buying power and enviable distribution network. Retailers who have attempted to go head-to-head with Wal-Mart on a price basis have not faired well. Wal-Mart's size (and buying power) and infrastructure have created a wide and sustainable economic moat. Competition cannot easily recreate the brand recognition, economies of scale and technical marvel that is Wal-Mart's distribution network, and for this reason Wal-Mart has a wide economic moat.

Consequently, a company's economic moat represents a qualitative measurement of their ability to keep competitor's at bay for an extended period of time, which ultimately translates into prolonged profits in the future. Economic moats are difficult to express quantitatively as they have no obvious dollar value, but are a vital qualitative factor in a company's long term success or failure and a vital factor in the selection of stocks in the Investopedia Advisor's Core Holdings portfolio.

If the concept of economic moats intrigues you, then perhaps some of the selections in our Core Holding model portfolio are for you. For example, Iron Mountain (IRM) in our estimation has a wide and sustainable economic moat. Since its addition to our model portfolio only a few months ago IRM has appreciated more than 40% at the time or writing.

Looking to cook up a market-stomping stock portfolio? Check out our FREE report "7 Ingredients to Market Beating Stocks" and get started right now!

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