Moat investing is based on a simple concept: Invest in companies with sustainable, competitive advantages trading at attractive valuations. One of the first steps in implementing this approach is finding companies with a moat.
A company’s moat refers to it’s ability to maintain the competitive advantages that are expected to help it fend off compeition and maintain profitability into the future.
This strategy was created by Morningstar, and it’s a form of an investment strategy that Warren Buffett utilizes with Berkshire Hathaway.
Morningstar identified five sources that make up a company’s moat.
- Switching costs. Switching costs gives a company pricing power by locking customers into it’s unique ecosystem. Beyond the expense of moving, they can also be measured by the effort, time and psychological toll of switching to a competitor.
- Intangible Assets. Though not always easy to quantify, intangible assets may include brand recognition, patents and regulatory licenses. They may prevent competitors from duplicating products or allow a company to charge premium pricing.
- Network Effect. A network effect is present when the value of a product or service grows as its user base expands. Each additional customer increases the product’s or service’s value exponentially.
- Cost Advantage. Companies that are able to produce products or services at lower costs than competitors are often able to sell at the same price as competition and gather excess profit, or have the option to undercut competition.
- Efficient Scale. In a market limited in size, potential new competitors have little incentive to enter because doing so would lower the industry’s returns below the cost of capital.
The goal with moat investing is to find companies that exhibit as many of these five characteristics as possible.
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