The 4 Economic Moats That Create Big-Time Winners
If you’ve been reading my investment commentary for long, then you know that I place a great deal of importance on economic moats. In the simplest terms, these are sustainable advantages that protect a business from marauding competitors seeking to pillage its profits.
Without some type of moat, it’s nearly impossible for a company to sustain superior returns on invested capital. All of the world’s most profitable businesses have some type of moat… Apple (Nasdaq: AAPL), Amazon.com (Nasdaq: AMZN), Wal-Mart (NYSE: WMT)…
Needless to say, it’s an enviable position. Most industries have nothing to prevent new rivals from crowding in and elbowing for space. Just take fast-food chains for example. They wage a never-ending battle for market share and must usually sacrifice profit margins to attract and retain customers.
The same is true of grocers, department stores, and countless other cutthroat industries.
But with daunting barriers to entry, it’s difficult (if not impossible) for newcomers to break in. So the market isn’t carved up into thin slices. The entire heaping pie is served up to one or two lucky incumbents.
4 Barriers To Entry
There are several different barriers that help dissuade would-be competitors from setting up shop. Here are four of the most common deterrents.
1. Regulatory Hurdles. Some industries are governed by layers of rules, regulations and oversight that scare away potential players. Slot machine makers, for example, must get the blessing of gaming control boards and other regulatory bodies before they can even think of putting a product on the market.
In some cases, the powers-that-be go out of their way to limit the playing field. The credit ratings business is a textbook example. Stringent SEC qualifications make it nearly impossible to get a toe-hold in this industry, so a small handful of lucky firms like Moody’s (NYSE: MCO) rake in all the profit.
Even garbage dumps can be a goldmine for investors. Waste must be hauled away somewhere, but nobody wants a new landfill in their backyard. Securing necessary permits, environmental zoning variances, and operating licenses can be a nightmare. That makes existing sites quite valuable.
Waste Management (NYSE: WM) owns more than 260 permitted landfills across the country. And with stout regulatory roadblocks to new ones, the company has few large-scale competitors. It even collects “tipping fees” from smaller regional players that use one of its sites.
2. Capital Requirements. Anybody with a few thousand dollars and decent skills in the kitchen can open up a new diner. That’s why they are found on every street corner. But some industries require hundreds of millions, or even billions, just to get in the game.
Building a state-of-the-art semiconductor manufacturing facility doesn’t come cheap. Same story for nuclear submarines. There are only a couple of shipyards capable of building these vessels on the Navy’s speed-dial, and General Dynamics (NYSE: GD) is one of only two companies that own them.
3. Patents and Licenses. Researching, developing, and ultimately commercializing a new product can be expensive and time-consuming. But if that product is awarded a patent, then the government itself is putting up a “keep out” sign to would-be rivals.
One of the most obvious examples involves pharmaceutical or biotech drugs. Abbvie’s (Nasdaq: ABBV) Humira, which is used to treat arthritis and other auto-immune disorders, rakes in billions in annual sales. It won’t face serious competition until 2023, when its protective U.S. patents expire and generic competition is introduced.
Then there are tech companies like Qualcomm (Nasdaq: QCOM), whose breakthroughs in the early 2000s are still generating royalty income from the sale of most mobile phones worldwide.
4. Contracts, Concessions, and other Agreements. Municipal, state, and federal governments often privatize certain functions or otherwise grant a limited number of permits to conduct operations. Those lucky enough to win one of these coveted concessions can milk them for years to come, often free of competition.
Case in point, there are hundreds of general aviation (i.e. private and charter plane) airports across the country such as Fort Lauderdale Executive and North Las Vegas. Refueling and concierge services are often handed to a single vendor, called a fixed-base operator (FBO). That’s a bit like operating the only gas station in town.
Action To Take
Quite a few of my investment recommendations over the years benefit from barriers to entry. That includes drug companies, power and gas utilities, and railroad owners (whose routes are protected by right-of-way permits), among others.
I’ve already thrown out a few picks that are worth looking into further. Buy my subscribers over at High-Yield Investing have been using stocks like this to build a powerful portfolio that throws off thousands of dollars in extra income each month. And it’s not too late for you to get started.
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