Investing in the stock market can be a confusing People often wonder what to look for when buying a stock. Over the course of the next two weeks, each day I will break down one component to look for when investing. This series is called the 10 Things To Look For When Buying A Stock. Number one on the list is to invest in companies with a wide economic moat.

Warren Buffett absolutely loves companies with wide moats. What is a moat? If you have ever seen a movie set during medieval times then you have probably seen a moat. Moats are those giant ditches filled with water that surround a castle. Drawbridges would have to be lowered so that visitors and entrants could cross over the moat. Moats are the first line of defense. They are great for protecting castles from enemy attacks.

Economic Moats

An economic moat works exactly the same way. It is a defensive component. Economic moats are major competitive advantages that protect companies from competitors and potential competitors. Companies with wide economic moats have a better chance of long term survival. Economic moats help to protect revenue streams, profitability, and market share. Always invest in companies with wide economic moats that are sustainable for a long period of time.

Types of Economic Moats

Strong Brand Name

A strong brand name is an example of an economic moat. You cannot put a price on brand name recognition. The names Nikes, Coca Cola, and McDonalds are worth billions of dollars to each of these companies. Customers will often by these products on brand name recognition alone. It may take new entrant years to build up a name that can compete against these corporate juggernauts.

Large Capital Requirements

A large capital requirement can also be an economic moat for a company. Have you ever wondered why there are so few companies in the telecommunications industry? It is because the industry is extremely capital intensive. There are huge upfront costs that keep new companies from competing against companies like Verizon and AT&T. It costs millions of dollars to establish networks, attract customers, and become a legitimate player in the telecommunications market.

High Customer Switching Costs

High switching costs may not be good for customers but they are great for companies. High switching costs act as a deterrent to switching providers. It is more likely that a customer will stick with a particular brand or service if switching providers would cost a significant amount of money, time, and energy. This is exactly why cable companies and cell phone companies charge cancellation fees to customers. Businesses will often remain clients of device makers and document storage firms due to the high switching costs.

Intellectual Property

Patents, copyrights, and trademarks can guarantee a company’s revenue stream for years into the future. Drug makers rely on patents to protect their creations and keep clients from selling similar products until expiration. Copyrights can help boost the revenue streams of movie studios, music labels, and book publishers.  A trademark gives a company a way to distinguish itself from its competitors.

Final Thoughts

These are just a few of the types of economic moats that exist. A business model, unique product, and pricing structure can all be economic moats for a company. Be sure to distinguish companies with true economic moats from companies with fake economic moats. For example, a company like CVS may appear to have a wide economic moat because you recognize the name but truly it does not. There is nothing that differentiates a company like CVS from Walgreens, Rite Aid, or Albertsons. Picking the winner in the competitive drugstore industry can be like throwing darts at a dartboard. A lack of an economic moat is the reason that I sold Gamestop back in 2008.

Ask yourself the following questions before investing.

– Does this company have an economic moat?
– Is the company’s moat wide, narrow, or non existent?
– What is this company’s competitive advantage?
– Is there a competitor that is rapidly taking market share from the company?
– Can this competitive advantage sustain the company over the next 10 to 20 years?

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