A unique edge
Moats once surrounded castles and protected them from intruders; the broader and deeper the moat, the more protected the castle would be. Companies also have moats, not literally but metaphorically - giving them a unique edge over competitors and protecting them long-term.
As an investor, you can benefit from investing in companies with advantages that distinguish them from their competitors.
“The key… is not assessing how much an industry will affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.” - Warren Buffett.
How to find companies with deep moats?
Moats aren't always easy to see. If you’re on the hunt for companies with wide moats, looking at past stock performance and financial statements can help. Here are some signals to search for:
Earnings and cash flow performance during bad economic times. Companies that seem to weather bad economic times have some attribute that allows them to keep going in tough times.
Cash on hand. Having cash on hand instead of investing it or paying dividends could be seen from different angles. Some argue that a company should spend their money, preferably at higher returns on investment than the individual investors can yield, or give it back to the investors. However, having lots of cash on hand will provide a strong cushion if revenue doesn't meet expectations.
Revenue and profits as compared to competitors. If there’s a gap in revenues and profits between the company you’re researching and its key competitors, the more profitable one probably has a wider moat.
Dominance of a single product or service. The maker or provider of a popular product or service is considered a moat, as customers prefer your company's offerings over some substitutes.
Powerful intellectual property. Unique patents on a particular product or technology that other companies have no option but to use.
Name recognition. Is the company name synonymous with the industry? Do people use the company's product or service simply because of its reputation and because they have been around for a long time?
The bottom line. Investing in companies with wide moats tends to be profitable in both good and bad times and often dominates the markets in which they operate.
You can’t think of a substitute for the product. Earnings are not only a factor of products or services inside the industry but also from the substitutes. Is there another way for customers to solve the problem than to go to them or their competitors?
The company can backward or forwards integrate, but their customers and suppliers can’t. The company you are analyzing can easily threaten their customers that they can compete with them, but the opposite isn't possible. The same thing goes for suppliers.
Customers and suppliers are small and undifferentiated. Small and undifferentiated customers and suppliers lead to high bargaining power for the company, as the customers and suppliers have no choice but to use the company’s products and services.
High and increasing ROIC. Does the company have the ability to deploy large amounts of incremental capital to high rates of return during long periods? These businesses with long runways of high-return investment opportunities can compound capital during long timespans.