With the deadline for taking up this year’s ISA allowance just a few weeks away, investors face a dilemma. Markets have been turbulent in 2016 and there’s growing uncertainty about the impact on shares from this summer’s EU referendum. Yet given the low-rate environment, the alternative options for parking money are far from appealing. At times like these it can pay to explore the long-term compounding gains that can be achieved from the strongest, most profitable and most durable companies around. To find them, it’s worth taking note of a major indicator of quality - the economic moat.
Protecting a competitive advantage
One of the leading authorities on buying and holding great quality companies for the long term is billionaire investor, Warren Buffett. His annual letters to to shareholders of Berkshire Hathaway are often peppered with references to what he calls ‘moats’. He once explained, for instance, that in good years and bad one of his main goals is “widening the ‘moats’ around our operating businesses that give them durable competitive advantages.”
The moat is a metaphor for the type characteristic that Buffett finds highly desirable in a business. It’s now a widely-recognised investment term that describes resilient, highly profitable firms. The idea is that great companies not only generate strong returns on capital, but they have ways of protecting those returns over the long term.
In his book, The Little Book that Builds Wealth, Pat Dorsey, a fund manager and former Morningstar analyst, put it like this: “Durable companies - that is, companies that have strong competitive advantages - are more valuable than companies that are at risk of going from hero to zero in a matter of months because they never had much of an advantage over their competition. This is the biggest reason that economic moats should matter to you as an investor: Companies with moats are more valuable than companies without moats.”
Dorsey goes on to outline four major hallmarks of economic moats, including:
- Intangible assets like strong brands, patents and hard-to-get regulatory licences
- Switching costs that discourage customers from moving to a competitor
- Network effects that instil sticky customer loyalty
- Cost advantages that come as a result of size and scale
There is no definitive set of rules for mapping these hallmarks to a company’s financials, but there are various clues to look for. Over time, durable businesses often have high operating margins…
