Protect your profits – buy firms with deep and wide moats

One of Warren Buffett's most memorable expressions is "economic moat", a phrase he coined in 1999. Just as castles are protected from marauding armies by a stretch of water, some companies boast wide protective moats keeping them well away from competitors seeking to encroach on their territory: one or more characteristics give them a sustainable competitive advantage and preclude a decline in profitability.

These stocks stand to outperform over the long term. We will examine several British, European and American companies of varying sizes to establish the key factors investors seeking wide-moat companies should look out for. It is also worth exploring how even the widest moats can dry up, as well as how they tend to develop in the first place.

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The companies that become verbs

The first factor to consider is a strong brand and they don't come any stronger than a company name that has become a verb. Google (a division of Alphabet) is a classic example. We use the phrase "google it" instead of "search for it", just as we say "hoover" instead of "vacuum". The term "xerox" used to be used instead of "copy" but is less common now.

It is rare to find a brand name used as a verb but where that happens it is a powerful moat factor, provided the company has a sizeable market share to capitalise on it as Google has and as Hoover and Xerox had in their heydays. Diageo is another firm that relies on brands: its customers will, for example, ask for a Johnnie Walker or a Lagavulin (single malt) rather than just a whisky. It has expanded from developed into emerging markets in large part thanks to the cachet these brands imply.

Exploiting a network

The network effect is another hallmark of a company with a wide moat. It is essentially a virtuous circle whereby an increase in users makes a service more useful and valuable, in turn attracting more users and stimulating growth.

Amazon is a good example of the power of network effects. People tend to go to Amazon for both its range of prices and wide selection of goods. The fact that Amazon has a large number of customers confers two major network benefits on the company. Firstly, suppliers are more likely to come onto Amazon to sell their wares because of the large number of potential customers there (over half of Amazon's sales are from third-party suppliers).

Secondly, your shopping experience is improved because others' experiences contribute to informative rankings and product reviews. The virtuous circle continues as more satisfied customers lure more traders onto the site, who in turn entice more customers. Competitors find it harder and harder to get a look-in.

The ability of a well-entrenched network effect to stymie competition is also illustrated by Visa. A credit card is of little use unless a large number of shops and other outlets accept it, but now that this is the case for Visa, it would be very difficult and expensive for a new entrant to build up a rival network. Another good example is internet property portal Rightmove, which has established such an impressive network that 95% of UK properties are now marketed on its website. That strong position is the reason its operating profit margin is a staggering 77%.

A boost from patents

A superior product, often protected by a patent, is another quality to look out for. The power of patented technology is highlighted by Novo Nordisk, the world market leader in treatments for diabetes, one of the world's fastest-growing major diseases. Its patented Victoza (liraglutide) for type 2 diabetes was first launched in 2010 in the US and had 2017 sales of DKK23.2bn (£2.8bn). That is over 25% of Novo's diabetes care sales and 16% higher than in 2016. The company's overall sales totalled DKK111bn (£13m). Liraglutide is also the basis of Novo's new anti-obesity drug.

Another interesting example is ASML (which I analysed in MoneyWeek in May). It spent 12 years developing its EUV (extreme ultraviolet) lithography, which can make much finer patterns on chips than any other technology and is therefore the basis for the next generation of more powerful semiconductors. ASML invests about 15% of sales in R&D each year to maintain its technological lead.

Keeping customers captive

If you can prevent customers taking their business elsewhere by making it a hassle or a major expense to switch, you are likely to secure an enduring competitive advantage. In the case of medical devices maker Medtronic, for instance, many specialists have been trained with and become highly familiar with its products, which range from heart valves to surgical staplers.

A specialist will be reluctant to change from a Medtronic product they understand and have used successfully in the past, particularly since Medtronic's research and development is very likely to come up with an improved version before a competing company does. ASML's only competitor in precision lithography is Nikon, and ASML is the only company with EUV next-generation lithography. That means that no customer will want to move away from ASML and shut the door on the next generation of semiconductor chips.

Apple has managed to create a "walled garden": apps can only be distributed on Apple's iOS app store if their developers adhere to Apple's guidelines. Apple keeps 30% of app income with the developer taking 70% and manages to keep tabs on and profit from new advances at the same time.

The upshot is that customers are tied into the Apple software ecosystem; leaving is difficult because there is no other version of the Apple operating system elsewhere (in contrast to the Android operating system) and people are likely to lose data on their apps if they move. A US poll last year found that 41% of Apple users said it was too painful to leave the iOS ecosystem; 80% planned to stay faithful to Apple.

Companies with wide moats often boast a large market share, having secured it through another moat factor such as the network effect or a unique product, as with Amazon and Apple. A large market share in turn widens a moat as it increases profitability, especially since large companies benefit from greater buying power and economies of scale.

High market share is particularly valuable when the market is essentially a duopoly, as is the case with ASML's leadership in precision lithography (competitor Nikon has a smaller share), Elekta and Varian in radiotherapy equipment, and Rightmove and Zoopla in property portals. In that last example, large estate agents were so worried about the duopoly's pricing power and Rightmove's high margins that they set up an agents' mutual portal.

When moats dry up

History tells us that even wide moats rarely last forever. A classic example is Kodak, which had excellent technology, a globally recognised brand and a massive global market share in silver halide photography. Kodak films were prominently displayed in high streets all over the world with Kodak chemicals and printing papers widely used. But thanks to a mixture of complacency and inertia, Kodak failed to respond effectively to the advent of digital photography and filed for chapter 11 bankruptcy protection in January 2012.

It was a similar story with Nokia, which was world market leader in mobile phones with a huge customer base. Nokia still had the largest market share as late as 2010 but was overtaken in 2011 by Android phones produced by Samsung. And BlackBerry was world number two until 2010. But both Nokia and BlackBerry (RiM) failed to make an effective transition to smartphones. A final example is Blockbuster Video which once dominated the home-video rental market, but failed to embrace online distribution and Netflix ate its lunch. Blockbuster went from 9,000 shops worldwide to just one.

Building a wide moat

There are two main routes by which a company can build a wide moat. The first is to take advantage of a new technology, new type of service or latent unmet consumer need to enter or create a market, build a market-leading position, and then maintain it as other companies try to enter.

The second is for a company in an existing market to develop its range of products and services by a combination of organic growth and mergers and acquisitions until it is the global market leader (or at least the number two) in its sub-sector, before maintaining and improving that position. Two examples illustrate these routes.

James Dyson entered a vacuum cleaner market that appeared to be mature and dominated by companies such as Hoover, Electrolux and Miele which used the razor/razor blade model to make money from replacement bags as well as selling vacuum cleaners. Then along came Dyson with his bagless dual-cyclone cleaners in modern designs with brightly coloured plastics and the best suction performance on the market. Dyson's DC01 upright became UK market leader only 18 months after launch.

Hoover responded by launching its own Dyson-like cleaner in 1999, but Dyson sued for patent infringement and Hoover was ordered to stop making its model in 2000. Dyson is an example of a moat initially based on patented technology. The Dyson brand is now a moat factor, as are its market share and customer relationships you only have to go into Currys to see that Dyson has larger and more effective displays than other vacuum cleaner brands.

Diageo is an example of the second route. Diageo was formed by the merger of Grand Metropolitan and Guinness in 1997 and has added many new brands since then. It is the world's top premium alcoholic drinks business with a wide range of spirits and beer in its portfolio.

It covers all the main spirits with world-leading brands in whisky, vodka, gin, rum, tequila and liqueurs, together with 13 beer brands including Guinness. In recent years it has made acquisitions in faster-growing emerging markets such as Brazil and India. Mature wide moat companies usually pay dividends; Diageo has a yield of over 2%.

The companies and funds to buy now

A reasonable balance between reward and risk is best obtained by identifying companies part way along route one (see above). They should be far enough along their development path to have built reasonably wide moats, but not so far along that growth and share-price gains have tailed off.

It is important to identify a candidate company's main moat factors and to understand how defensible and long lasting these are likely to be, and it is wise to add diversification by investing in several such companies spanning different sectors.

Although they are very large, some of the companies in the table on page 20 are still growing quite fast and offer scope for further share-price appreciation. Examples are Alphabet (Nasdaq: GOOGL), Amazon (Nasdaq: AMZN) and Salesforce.com (NYSE: CRM). The latter was founded in 1999, listed in 2004 and is the least well known. Note its ticker of CRM appropriate for the world leader in customer relationship management. It's a pioneer of SaaS (software as a service) and global leader in CRM with $1bn+ clouds in sales, service, applications and marketing. It is now the world's largest pure-play SaaS company, with revenue growing at around 25% per year. ASML (Amsterdam: ASML), the dominant company in precision lithography, is a sound "picks and shovels" company.

These firms pay no, or minuscule, dividends. More income-orientated investors can opt for slower-growing wide-moat companies that are more generous. Diageo (LSE: DGE); Medtronic (NYSE: MDT) and Novo Nordisk (Copenhagen: NOVO-B) fit the bill here. They all pay 2% or more.

Medtronic, a world leader in medical devices, acquired Covidien in 2015 to strengthen its position in acute hospital care. It has lower growth than Amazon or Salesforce with a forward price/earnings (p/e) ratio of 16.4 and dividend yield of 2.1%.

Novo Nordisk is the leader in the diabetes market and also boasts a profitable biopharmaceuticals range. Diabetes is one of the world's fastest-growing major diseases and this underpins future growth. Next year's p/e is 18.3, there is a current yield of 2.5% and new drug launches support its wide moat.

Turning to medium-sized companies with wide moats, Abcam (LSE: ABC), the "Amazon of antibodies", supplies two-thirds of the world's biotech researchers. It is growing fast but the shares are pricey, being only 2% off their all-time high. Renishaw (LSE: RSW) is a world leader in precision metrology with excellent patented technology, strong customer relationships and a high market share in its niche. However, the shares are only 8% below their all-time high and RSW has a volatile share-price history. In both cases investors may wish to wait for a lower entry point.

Investors can also gain exposure to large-cap, wide-moat growth companies through an investment trust such as the Scottish Mortgage (LSE: SMT), Polar Capital Technology (LSE: PCT) or the Alliance Trusts (LSE: ATST). All three have wide-moat growth companies such as Alphabet, Amazon, and Salesforce in their top ten holdings. Investors may also wish to research the VanEck Vectors Morningstar US Wide Moat ETF (LSE: MOAT). It tracks the Wide Moat Focus index, comprising around 40 US companies that data analysis group Morningstar reckons will be able to fend off competitors for 20 years.

There is also an ETF tracking Morningstar's Global ex-US Moat Focus index, a group of companies with moats listed outside America the VanEck Vectors Morningstar International Moat ETF (NYSE: MOTI).