Buy Firms With Big Moats

Investment Strategy: Buy Firms With Big Moats


Moats are there to make castles difficult to attack. The same goes for companies, according to Warren Buffett. In 1999 he said "the key to investing is… determining the competitive advantage of any given company and, above all, the durability of that advantage". So one of the keys to picking winners is to find firms with strong defences - a wide 'economic moat'. But what does that mean?

Why moats matter
Advantages don't last. That's especially true in the corporate world. As soon as a business looks to be gaining a lead, making decent margins and expanding, other firms will try and break into their market. What stops them is the size of the economic moat enjoyed by an incumbent. Fair or not, long-lasting firms have an edge - something that makes them difficult to imitate quickly. Here are four traits to watch out for, as identified by Harvard professor Michael Porter.

1. Low-cost production
Given enough time, I could probably make a car and sell it. But could I do it on a large scale and at a low price? Firms with wide moats can. How? They can use their size to cut deals with suppliers and workers to keep production costs down. And their scale gives them the distribution clout to keep delivery costs to the end customer low, too. Getting to this sort of scale and negotiating these deals takes time and money - so new entrants have their work cut out trying to compete.

2. High switching costs
A firm with a wide economic moat often has a 'sticky' product. In short, it's not easy for a customer to find an alternative. For example a large drug-making firm may be the only producer of a particular drug. Even if it isn't, patients or doctors may not trust cheaper imitation products.

Equally, many IT firms are able to lock clients into multi-year contracts. Certainly a client - perhaps in the public sector - can pull out of a contract, and with the government planning to cut spending we're likely to see this happen in the near future. But doing so may cost a fortune. As Labour MP Geoffrey Robinson has pointed out, the NHS has wasted billions on IT thanks to being held hostage by several large consultants on long-term contracts. This is bad news for the taxpayer - but it certainly provides such consultants with a strong competitive advantage.

3. Intangible assets
Many firms hold patents or licences that make it tough for a rival to break in. For example, drug firms have exclusive rights to make their products for a number of years before competitors are allowed to produce copies. And getting through the regulatory process also requires scale and expertise. This makes it very hard for smaller rivals to grow and get new drugs approved without finding larger partners to work with. Equally an oil firm such as BP with a licence to drill in, say, Russia has a natural competitive advantage (assuming they have chosen their target country correctly).

Strong brands also create a moat. You might have invented a drink that tastes as good as Coca Cola. But challenging a brand which has been built over years of advertising spending and consumer trust requires huge clout and would take a long time to achieve. Shaving giant Gillette is a good example of a firm which continues to thrive, despite the fact that its products are usually more expensive than the competition's. Much of that is down to years of expensive brand building using celebrities such as David Beckham to promote the product.

4. The network effect
Sometimes firms can become almost too big to fail commercially. For example, the sheer numbers of people now using online auction site eBay make it very hard for anyone else to take it on - and the value of the service increases in turn as more and more people use it. After all, if you're going to sell something, you want to go to the auction site with the most potential customers. So copying the company's business model would be tough, let alone persuading its customers that your version is better. And it gets even harder the faster it expands.

What to buy
One sector that still enjoys a very wide economic moat is big pharma. There are fears about the impact of patents being removed from certain key drugs over the next few years - but rivals will still find it difficult to compete with the product pipelines that drug majors enjoy thanks to their hefty research and development spending, plus their ability to buy in new drugs from smaller rivals.

More to the point, many of the bigger firms in the sector are just plain cheap. At this time, in the UK, we like AstraZeneca (LSE: AZN), on a forward p/e of just over seven, and GlaxoSmithKline (LSE: GSK) on a forward p/e of around 9.5. The stocks pay out current year dividend yields of 5.4% and 5.2% respectively.