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Buffett’s long-term competitive advantage

Mark LaMonica, CFA  |  26 Aug 2020Text size  Decrease  Increase  |  
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Over his long and storied investing career Warren Buffett’s investment philosophy underwent a remarkable evolution. Early in his career Buffett was a protégé of famed value investor Benjamin Graham and looked for companies that were selling at less than their liquidation value. Under the influence of Charlie Munger, Buffett later focused at paying a fair price for great companies.

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A great business is one that has a long-term competitive advantage, which allows it to fend off competitors while investing capital at a high rate of return. The long-term competitive advantage of a business is called an economic moat. Just as moats were dug around medieval castles to keep enemies at bay, economic moats protect the high returns on capital enjoyed by the world’s best companies. A company with an economic moat is quite rare because any time a profitable product or service is developed other firms respond by trying to produce a similar version, or even improving on the original version. Some companies are able to withstand the relentless competition of the marketplace and these are the wealth-compounding machines that an investor wants to find and own.

At Morningstar we believe there are five major sources of competitive advantage, or economic moat:

  1. Intangible assets: These can include brands, patents, or government licenses that explicitly keep competitors at bay. This can be seen in pharmaceutical companies with patent protection or with consumer brands that have long-standing and well-regarded brands.
  2. Cost advantage: Firms that can provide goods and services at lower costs have significant advantages over rivals as they can either undercut their rivals on price or sell at the same price and earn a higher profit margin. Generally, moats based on cost advantage are due to economies of scale. Economies of scale is defined as the cost advantages that companies obtain due to the scale of their operations with the cost to produce a product or service going down as output increases.
  3. Switching costs: Switching costs refer the inconveniences or expenses associated with a customer switching from one product to another. Banks can be good examples as it is time-consuming to switch bank accounts once you have set up direct deposits and payments.
  4. Network effect: The network effect occurs when the value of a particular good or service increases as more people use the good or service. Social media sites are perhaps the best example as a low number of members provides less of a benefit to a user than a high number of members.
  5. Efficient scale: Efficient scale applies to companies that serve limited markets where there are a small number of competitors. Potential competitors are discouraged from entering the market based on the small opportunity. An example can be a pharmaceutical company that produces drugs for diseases that only affect small patient populations.

Our analysts evaluate each of the 1600 global stocks we cover and assign economic moats to those that we believe have a sustainable competitive advantage. A company whose competitive advantages we expect to last more than 20 years has a wide moat; one that can fend off their rivals for 10 years has a narrow moat.

We provide a list of Australian companies our analysts have assigned with an economic moat rating.

is a product manager, individual investor, Australia.

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