The One Investment Trait Buffett Looks For Above All Others
When he buys a stock, Warren Buffett places more emphasis on one factor above almost any other.
Since 1986 he has mentioned this single trait more than 20 times in his annual shareholder letters. He calls it “essential for sustained success.”
However, you won’t find it listed on a company’s balance sheet. Its value doesn’t rise and fall with the market. And even if a company reports great earnings, the worth of this one advantage still can’t be calculated.
But that doesn’t keep it from being a company’s most valuable possession.
Take the nasty bear market of 2008 and 2009. From its peak to trough, the S&P lost more than 55%. No investment completely avoided the downfall.
Well, almost no investment. Of the 500 stocks in the S&P, only nine made money during that period.
Of those nine stocks, six of them (two-thirds) had this advantage.
But this advantage also helps these stocks beat the market in uptrends, too. After all, Buffett has made billions thanks to companies with this trait.
So what single advantage can capture the attention of Warren Buffett… help a stock beat the market in an uptrend… and help it fall less in a downtrend?
That advantage is a term originally popularized by Buffett himself — an economic moat.
As Buffett puts it…
“A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns.
“Therefore a formidable barrier such as a company’s being the low-cost producer or possessing a powerful world-wide brand is essential for sustained success.”
– Warren Buffett, 2007 Berkshire Hathaway Shareholder Letter
Economic moats protect a business from competition. That helps the company with a moat earn unusually high profits.
Let me give you an example…
Everyone knows Microsoft’s (Nasdaq: MSFT) incredible story. In the 1970s, Paul Allen and Bill Gates created the company, reportedly earning $1 million within their first year of business.
That’s where Microsoft’s “moat” began. But it was the introduction of the Windows operating system in 1985 that turned its moat into one of the widest in history.
Approximately 70% of computers run a form of Windows right now. Microsoft generated $14.8 billion in revenue from Windows in fiscal 2015 — nearly 30 years after it was first introduced.
But how — especially in an industry like technology, which changes so fast — has Microsoft been able to stay on top of its market?
Few people “love” Windows the same way that they seem to “love” their iPhone… or their favorite drink at Starbucks (Nasdaq: SBUX). Yet billions of people continue to use the product day after day, year after year.
That’s because Microsoft — and Windows in particular — enjoys a huge economic moat due to high switching costs.
High switching costs mean that the benefits gained from using another product are outweighed by the “costs” of switching. If I wanted to switch to another operating system, I would have to buy the new operating system, and I’d also have to spend time learning how to use it.
And that’s not to mention that many software programs are built to run only on Windows, creating another hurdle to switching.
That moat has made Microsoft’s founders, Bill Gates and Paul Allen, billionaires several times over.
But investing in economic moats can be a tricky thing…
As I said, moats aren’t listed on a balance sheet or income statement. And there is no definitive list of what constitutes a moat and what does not.
But while there isn’t an exact list of moats, the most common ones are easy to spot…
Low-Cost Provider — A company that can provide the lowest price for the same product can essentially shut its competitors out of a market. This is the reason behind Wal-Mart’s (NYSE: WMT) growth over the past several decades.
High Switching Costs — I explained how Microsoft has built a moat around its business thanks to high switching costs. These costs keep customers loyal to a product, even if better alternatives exist.
The Network Effect — How has eBay (Nasdaq: EBAY) cornered the market in online auctions? Sellers want to list their products on the site because of the huge number of buyers that shop there. And buyers visit the site to find the most options from sellers. Because of its vast network of users, no other auction site rivals eBay’s popularity.
Strong Brand Name — Coca-Cola (NYSE: KO) is one of the most dominant companies on the planet. Much of its advantage comes from its powerful brand name. That’s why even though there are literally hundreds of substitutes, Coke is able to dominate its competition.
Intangible Assets — Pharmaceutical companies have been able to pay their investors billions of dollars in dividends thanks to their patents on drugs, which shut out competition. Patents and other intangible assets (like trademarks) can protect a company from direct competition.
Now, investing in moats is no guarantee that a stock will beat the market. Plenty of other factors come into play. But if the world’s greatest investor has made billions of dollars investing in “wide-moat” companies, don’t you think you should too?
That’s why economic moats are one of the key traits I looked for when making my list of The Top 10 Stocks For 2016. In this much-anticipated annual report you’ll find a small, elite group of stocks uniquely positioned to deliver market-crushing gains. One of these picks is a Silicon Valley leader with a moat that gets wider every year, giving it the potential to soar.
A wide economic moat is just one of the advantages a stock must have to make the cut — that’s why each year my list has beaten the market more times than Warren Buffett’s Berkshire Hathaway. While these stocks share a history of outperforming the market, many of them are even more known for their reliably generous dividend raises.
For full access to my picks for the Top 10 Stocks for 2016 click here.