What if someone told you that he has a formula for generating above-average returns in the stock market for a long period of time?
How much would you pay for that formula?
Here’s the good news: You don’t have to pay for it. And the best part is, you don’t have to look anywhere to find it.
The secret to generating above-average returns is from Warren Buffett himself. According to Warren Buffett, the key to successful investing is finding companies that possess a durable economic moat.
Defining Economic Moat
A moat is a broad ditch filled with water that surrounds the castle. The primary purpose of the moat is to make it difficult for enemies to attack the castle. In an analogy, a company possessing a wide economic moat stops its competitors from attacking the company’s competitive position.
Here are 6 ways how to find companies with durable economic moats:
1. Identifiable brand. It’s easy to spot a company with an economic moat. Start with a famous brand. Think of Coca-cola, McDonald’s, Mercedes Benz, Starbucks, Disney and Apple. A strong brand sticks to the consumer’s mind. When you think of Disney, you associate to happiness. No wonder Disney is one of the most profitable companies in the world.
2. Intangible Assets like exclusive rights or patents. A patent or copyright suggests that the company has the exclusive right to manufacture or sell the products. For example, a pharmaceutical company that manufactures and sells profitable drugs is protected from patent and rights. That is why when a patent is set to expire, investors of a pharmaceutical company usually is worried about the future outlook.
3. Focus on long-term profitability. A company that focuses on long-term profitability creates an advantage from anticipating unforeseen events in the future. This exercise will also guarantee that the company will make strategies that will have impact on future growth.
4. High Switching Costs. Companies that have products that have high switching costs usually have an advantage. Think of a very long time Microsoft user. It would take him several months before getting used to an Apple Computer so he’d probably decide to ditch the idea of getting one.
5. High barriers to entry from High Capital Requirements. There are industries that require high capital to enter. This creates a natural economic moat. This also limits future competition. A good example of this is a telecommunications company. For a new entrant to go head to head with an incumbent, it will require huge capital investment.
6. Low cost producer. A low cost producer creates a moat as it sells lower priced goods to its customers. The source of cost advantage can be learning curve, a patented technology that can lower manufacturing costs or location that produces overall lower cost of production. Competitors could not lower their prices as it would cause margin compression.
The best part of the search process is that these companies are everywhere. You don’t have to be a genius to figure out that the company has an economic moat.
Here’s a practical suggestion: Go to a supermarket and notice what products people are buying. More often than not, these brands are produced by companies that possess economic moat.
What’s the formula to above-average returns in stock marketing investing?
Two words – Economic Moat