What are Moats in Investing?

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. Some examples of companies with substantial moats are Alphabet, Amazon, and LVMH.

Moats aren't always easy to see. If you’re on the hunt for companies with wide moats to invest in, looking at past stock performance and financial statements can help. Here are some signals to search for:

1. 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 when the economy takes a downturn.

2. 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 its 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.

3. 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, higher profitability could be a sign of a wider moat.

4. High and increasing ROIC. Does the company have the ability to deploy large amounts of incremental capital at high rates of return during long periods? These businesses with long runways of high-return investment opportunities can compound capital during long timespans.

5. 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.

6. Powerful intellectual property. Unique patents on a particular product or technology that other companies have no option but to use.

7. Name recognition. Is the company name synonymous with the industry? Do people use the brands' product or service simply because of its reputation and because they have been around for a long time?

8. 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?

9. The company can backward or forward integrate, but its 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.

10. 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.

11. 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.