Retreat from risk: buy stocks with moats

A moat represents a castle’s first line of defence against intruders. The bigger and deeper it is, the better. An ‘economic moat’ does the same thing for a company – and it’s an absolutely critical feature to look out for before you invest in any stock. An economic moat gives companies staying power. As we’ll discuss in a moment, the moat can come in a wide range of guises – from a brand, to a patent, to regulatory constraints – but in essence, it’s any aspect of the business that allows it to keep making money, and stops other firms from stealing its customers.

Companies with economic moats are highly sought after. They are central to the success of US investor Warren Buffett, for example. According to Buffett, buying companies with moats is a great way to reduce your risk as an investor. That’s because if a company’s advantages have allowed it to make good money in the past, it will probably have a decent chance of continuing to do so in the future.

By buying these businesses at the right time, and then holding on for a long period of time, the investor can compound the high returns the company makes, and potentially become very rich. That’s why Buffett invested lots of money in big companies such as drinks giant Coca-Cola, consumer goods group Gillette and credit-card firm American Express.

How to find a company with a moat

So how do you find a moat? One of the easiest ways is to look for a company that has a consistently high return on capital employed (ROCE). Good companies earn lots of profit as a percentage of the money they invest – they deliver good returns for their investors. However, these high returns also attract competitors who want a slice of the cake.

All else being equal, that will erode returns over time. So if a company has maintained a high ROCE for a long while – say ten years or more – that suggests it could have a moat that offers a strong defence against rivals.

But it’s not just about the numbers – you also need to understand what lies behind them. Why does the moat exist? And can you continue to rely on it? One common form of moat is that the company sells branded products. Brands are a symbol of quality that customers identify with. They will often stay loyal to a brand – and pay a premium for it – because they trust it. Brands can take years to build up and can be defended with large advertising budgets that a prospective rival may struggle to match.

Related to brands are products that are habit-forming, such as tobacco or alcoholic drinks – products that consumers feel compelled to buy.

Another example is products that are deeply entrenched within a business, such as Microsoft Office software. Here, users are loath to change their habits because of the cost and hassle of doing so, which means a lot of repeat business for sellers.

Patents are another example of a solid economic moat. These protect products such as prescription drugs or technologies from competition, which is why pharmaceutical companies have had very high returns in the past. Just bear in mind that patents do not last forever. And they are not much use if a better product comes along.

You should also look for companies that have cost advantages. The sheer size of a company can give rise to what is known as ‘economies of scale’. This means they can spread the cost of making something over lots of units, which means they can make things more cheaply than smaller competitors. They may also be able to buy goods and services cheaper as their size allows them to obtain bigger discounts.

One thing that shouldn’t be seen as a moat is company management – a moat usually comes from a company’s assets and products. Good management matters, there’s no denying it. But US investor Peter Lynch offered some good advice when he said: “invest in a business that any idiot could run because some day one will”.

When to buy moat companies

Frustratingly, it’s easier to identify companies with solid moats than it is to buy their shares at a decent price. That’s because these companies are in demand, and also tend to be well known. Buying a great company at too high a price is one of the biggest mistakes an investor can make, and usually ends
in disappointment.

So you have to be patient. Build a watch list and only buy these companies after they have suffered a temporary setback, or when the overall stockmarket is crashing. I’ve listed the details of four promising companies with excellent, durable moats below.

Four companies with deep moats

Each of these four stocks could be considered to have some form of moat, based on the characteristics mentioned above. The shares aren’t cheap But high-returning companies such as British American Tobacco or specialist engineer Rotork, could be worth considering at today’s share prices. Put the others on your watch list.

Company Ticker Share price ROCE P/E ratio
Coca Cola NYSE: KO $41.69 16.20% 20.0
BATS LSE: BATS 3,566p 30.20% 16.6
Reckitt Benckiser LSE: RB 5,210p 21.60% 19.9
Rotork LSE: ROR 2,630p 45.30% 19.9