What Makes a Moat: How to Spot the Strongest Stocks on the Market

By TradeSmith Research Team

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When I joined the TradeSmith team as Senior Analyst, I was drawn to the mission of helping folks take control of their financial future by using hedge-fund level insights designed for individual investors.

In other words, it’s a place that is in your corner.

As a part of that, while I can’t provide personalized financial advice, I want to answer as many of your great questions as possible.

Case in point, recently Leilane R. wrote in, saying, “I would like to find more companies with moats.”

Well, I’m glad you brought up this topic, Leilane, because today’s turbulent stock market puts a big premium on identifying quality stocks with wide moats, and it’s something that my friend and colleague TradeSmith CEO Keith Kaplan has been pounding the table about.

I don’t want to bore anyone with a history lesson, but let me briefly touch on how the idea of a moat relates to investing in businesses.

In ancient times, a moat was basically a swampy ditch dug around a castle or fortress, which was used as a defensive move to keep the enemy away.

When it comes to investing, a moat surrounding a company’s business amounts to basically the same thing: It offers protection to keep the enemy, in this case the competition, far away.

Businesses that enjoy durable, competitive advantages naturally have what’s known as pricing power. This means they can deliver consistent sales and profits no matter what.

Businesses like this effectively keep the “enemy” far away, whether that enemy is other competitors, inflation, recession, or anything else that can be thrown at it.

If you can put some distance between your business and the many things that could potentially go wrong, then your business is more durable and should also be worth more to investors. One thing to keep in mind when it comes to investing in moat stocks is valuation. There are plenty of great companies with businesses that enjoy wide moats. But they aren’t always available at an attractive price.

Think about Microsoft Corp. (MSFT). This company clearly enjoys enormous competitive advantages and barriers to entry from competitors. But MSFT shares are still down nearly 30% this year.

The reason why has everything to do with its high price of almost $350 per share late last year. At that price, MSFT was trading at more than 38 times trailing earnings per share (EPS). That’s expensive, especially considering Microsoft’s sales and profit growth of less than 20% recently.

As Warren Buffett has famously said: “Price is what you pay. Value is what you get.”

You must always be mindful of how much you’re being asked to pay, even for the highest-quality businesses with wide moats.

How to Spot a Moat

Researchers at Morningstar.com identified some of the key attributes of stocks that enjoy a healthy moat around their businesses. Here are some of the key qualities to look for.

High Switching Costs: If it is too expensive and/or too much hassle for customers to switch from one product or service to another, then customers are less likely to jump ship. This helps lock in customers for the long term, and it gives companies pricing power. Stocks that are insulated by regulatory hurdles are a good example.

Aerospace and defense giant Lockheed Martin Corp. (LMT) is a match here because the U.S. military is its prime customer. And it’s not like you can buy parts for an F-35 stealth fighter from anyone else at any price. Lockheed Martin has benefits of scale and regulatory advantages.

Intangible Assets: Patent protection, trademarked technology, and brand loyalty are all examples of intangible assets that keep the competition at bay. And intangibles can provide a business with a big and durable competitive advantage.

Both Coca-Cola Co. (KO) and biotech king Amgen Inc. (AMGN) fit the bill here.

Network Effects: This happens when the perceived value of a product or service grows as the number of customers using it increases. Technology companies like Apple Inc. (AAPL) or Microsoft are prime examples of this.

The value of the iPhone isn’t just in its initial price tag. The value is enhanced by all the extra features the phone can provide, like its Game Center and FaceTime. Once a friend or family member uses the Game Center or wants to chat primarily through FaceTime, you may feel inclined to pick an Apple product to be able to connect with them.

Companies that offer advanced technology and the ability to connect in online communities enjoy network effects.

Cost Advantages: Any company that can become THE low-cost producer of a good or service, and can maintain that leadership, enjoys competitive cost advantages. This is one of the most durable sources of a business moat.

Anheuser-Busch InBev (BUD), the world’s largest brewer, is a low-cost leader, which gives it huge pricing power.

Staying Power: When you do find a stock with some or all of these advantages, you also need to make a judgement call about whether its moat will last. Competition is fierce in corporate America, not to mention worldwide.

Stocks that generate big profits become a target for competitors. That’s why it’s important that a company has multiple competitive advantages and can sustain them over the long term.

A relatively easy, decisively indicative test here is to simply ask yourself, how long has this company been dominant? That brings us back to Coke, one of Warren Buffett’s largest holdings.

First, Coca-Cola enjoys several key competitive advantages that give it a wide moat.

1. It has plenty of intangible assets, particularly its brand loyalty among consumers — not to mention its secret formula.

2. Its enormous size and scale gives it a low-cost advantage as well as pricing power.

Second, Coke has enjoyed this wide moat for a long time, and its dominance is likely to continue.

Coca-Cola has been delivering “a coke and a smile” to folks as a public company for more than 100 years now. And its business is so stable and dependable, due in large part to its economic moat, that the company has increased its dividend payout for 60 years in a row.

Now that’s what I call a durable competitive advantage. In fact, the only quibble I have with Coke is its valuation. The shares are trading at nearly 26 times EPS, while profits and cash flow have only grown 2% over the past 10 years. That’s expensive.

I hope that helped you understand how to find more companies with moats and how to evaluate them, and I would love to see more of your questions.

Whether they be about inflation-resistant stocks, recession-resistant stocks, my outlook for the rest of the year, or anything else you would like to know more about, you can send your questions here.