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!

Related Articles
  1. Investing News

    What Does the Fire Monkey Mean for Your Portfolio?

    The Chinese new year this year corresponds to the monkey, a quick-witted, playful, tricky figure that means well but has a penchant for causing trouble.
  2. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  3. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  4. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  5. Retirement

    Warren Buffett's Investment Lessons for Retirees

    For those in retirement, Warren Buffett's clear, timeless advice on investing is worth a look.
  6. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  7. Investing News

    Chipotle Served with Criminal Probe

    Chipotle's beat muted expectations and got a clear bill from the CDC, but it now appears that an investigation into its E.coli breakout has expanded.
  8. Stock Analysis

    Analyzing Sprint Corp's Return on Equity (ROE) (S)

    Learn about Sprint's return on equity. Find out why its ROE is negative and how asset turnover and financial leverage impact ROE relative to Sprint's peers.
  9. Stock Analysis

    Why Alphabet is the Best of the 'FANGs' for 2016

    Alphabet just impressed the street, but is it the best FANG stock?
  10. Investing News

    A 2016 Outlook: What January 2009 Can Teach Us

    January 2009 and January 2016 were similar from an investment standpoint, but from a forward-looking perspective, they were very different.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
Trading Center