Why Economic Moats Are Important to Investing

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Source: Thinkstock

Source: Thinkstock

One of the best investment strategies is to focus on companies that have what is known as a wide economic moat. A real life moat is constructed around a property in order to protect it and its owners from invaders. In the analogy at hand, these invaders are competing companies. So a company with a wide economic moat is well protected from potential competitors.

Moats can appear in many different forms. There are three that are especially important to successful investing. The first is the capital intensiveness of a business. If you invest in a business that is fully operational but which would require a lot of capital in order to replicate, then this business has a wide economic moat. Take, for instance, the rail transport industry and compare it to the trucking industry. Anybody with a few hundred thousand dollars can buy a couple of trucks, advertise on Craigslist, and compete, at least on a small scale, with large trucking companies such as Swift Transportation (NYSE:SWFT). However this isn’t the case for the rail transport industry.

It would take hundreds of millions of dollars, if not more, in order to build the infrastructure necessary to compete with the likes of Union Pacific (NYSE:UNP) and CSX (NYSE:CSX). Therefore there are only a handful of rail transport companies, and we can predict that these same companies will continue to control the industry for years to come. Similar moats can be found in other industries where companies need a lot of capital intensive infrastructure in order to compete. Two such industries include telecommunications (E.G. AT&T (NYSE:T), Verizon (NYSE:VZ), Sprint (NYSE:S), and the cashless payment industry “e.g. Visa (NYSE:V), Mastercard (NYSE:MA), American Express (NYSE:AXP), eBay (NASDAQ:EBAY), and so on.”

The second sort of moat comes in the form of brand recognition. Consumers and businesses are going to do business with companies they trust, and companies with well established brands are going to have economic moats. For instance Coca Cola (NYSE:KO) can sell its products pretty much anywhere it wants to, and because consumers recognize the brand they will purchase the product. But if I were to start my own cola company and call it “Ben’s Cola” I would have a hard time selling it if it sits next to “Coke” products on the grocery store shelf. I would have to do a lot of marketing and prove to consumers that they should purchase my product over the pre-established products. Since it is so easy for Coca Cola to sell its products its business is far less risky than companies with weaker brands, and they should perform better in the long run.

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