Types Of Economic Moats To Help You Make Money
There are many factors you should consider when choosing those best-of-breed businesses that have great growth potential and are capable of generating substantial profits for you over the years. So, how important is it that a company has a well-established economic moat? The short answer: crucial.
An economic moat refers to the notion that the business has some durable competitive advantage, not unlike a moat that protects a castle from attack. The wider the moat the easier it is to fend off attackers.
Finding a business with a wide moat is key to finding a successful business to own; the wider the moat, the more predictable its future 20 years down the road. Having a competitive edge, allows for a company to have a degree of predictability.
As an investor, you are looking for not only sustainable growth rates but also consistent growth in cash flow, equity and sales over a 5 to 7-year period of time. With increasing cash flow, profitability for both the business and you the shareholder arises.
With increasing cash flow, a best-of-breed business can whether the ups and downs of the economic business cycle paying off debt when needed or investing capital for expanding into new markets.
Wide moat companies are also protected from inflation since their monopolistic position enables them to raise prices at will.
Here are seven types of economic moats to look for in a potential business:
Brand a product or service youre willing to pay more for because you know and trust it. Companies like Disney and Nike have good brand moats.
Secret – a patent, copyright or trade secret that makes competition difficult or illegal. Examples of these companies are 3M, Pfizer and Apple.
Toll – having exclusive control of a market through government approval or licensing thus being able to charge a toll for accessing that product or service. Such businesses as PG & E, a utility company and Time Warner a media business fit the mold.
Switching – being too much trouble to switch to another provider due to the high monetary and time costs. Microsoft and H & R Block are two good examples.
Low Price – products priced so low no one can compete because they enjoy massive economies of scale due to a huge market share. Both Home Depot and Wal-Mart are examples of businesses that have used pricing to establish an economic advantage.
Network Effect – the ability to quickly dominate a network of end-users by being first in the market. EBay was the first online auction business to dominate the North American market.
Unique Corporate Culture – a way of doing business that would be difficult to duplicate in another business environment. Southwest Airlines benefited from this type of economic moat in the early years.
You need not find a company with multiple moats to consider it to be a potential investment candidate. It should have one moat that seems hardest to cross and one that is sustainable long-term. Once again, the establishment of a viable economic moat shows up in the fundamentals. Companies with consistently high growth rates of over 10% per year in sales, equity and free cash over many years are the ideal candidates.