Do you know the most important thing Warren Buffett looks for when evaluating a company?
It's not a debt-free balance sheet, a history of strong free cash flow generation, or a strong corporate culture. It's not even an undervalued stock price -- although that is certainly a hallmark of most Buffett buys.
Nope, the first thing Buffett looks for is an economic moat -- the bigger the better.
The key to the castle
Buffett himself coined the term "economic moat." It refers to a business' competitive advantages that keep other companies at bay. Finding companies with significant, sustainable competitive advantages has been key to Buffett's phenomenal performance. As the Oracle of Omaha told Fortune magazine:
The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company, and above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.
Emphasis on "sustainable"
Astute readers (and fans of italics) will notice that I placed special emphasis on the sustainability of a company's competitive advantage. I wanted to draw your attention to that point because in business, most competitive advantages are short-lived.
Just look at IBM. In the early 1980s, the company was largely responsible for popularizing the personal computer. However, competitive pressure made the PC a commodity item, while up-and-coming companies unveiled famously efficient business models that further compressed IBM's profit margins.
As a result, IBM's PC division shifted from a growth driver to a value destroyer. IBM ultimately sold its struggling PC business to Lenovo in 2004 for a modest $1.75 billion.
Fame is fleeting
As IBM proved, cutting-edge technology may be cool, but it's not a source of sustainable competitive advantage.
And according to hedge fund manager and former Morningstar equities strategist Mark Sellers, the same can be said of a good management team, a catchy advertising campaign, or a hot fashion trend. These attributes may produce temporary advantages, but they are likely to erode over time, or be duplicated by competitors.
As far as Sellers is concerned, there are only four sources (PDF file) of sustainable competitive advantage -- the key to a true economic moat:
1. Economies of scale
This is a fancy term that economists love to throw around. Basically, it means that bigger companies can offer products at a lower cost than smaller ones.
Target (NYSE: TGT ) is a good example of economies of scale in action. Because of its mammoth size, Target wields tremendous bargaining power over its suppliers, and it can spread its operational costs across a wide store base. The company can thus undercut its competitors on price while still turning a tidy profit.
2. The network effect
The network effect occurs when the value of a service increases in direct proportion to the number of people using it. For example, eBay becomes more useful as the pool of buyers and sellers grows -- although it also becomes increasingly difficult to snag that vintage mint-condition Rolling Stones 1972 U.S. tour poster.
Network effects are also largely responsible for the success of credit card companies such as Discover Financial Services (NYSE: DFS ) . After all, the more merchants that accept these cards, the more likely users are to carry them. Meanwhile, the more users that carry them, the more likely merchants are to accept them!
At The Motley Fool, we also benefit from network effects. The more members join our Stock Advisor community, the more powerful our discussion board community becomes.
3. Intellectual property rights
Companies such as GlaxoSmithKline (NYSE: GSK ) and Genentech (NYSE: DNA ) have been long-term market-beaters, in large part because of the strength of their patent portfolios. These companies have proved to be adept at transforming the money they've spent on research and development into profitable products.
Truth be told, the beverages produced by Hansen Natural (Nasdaq: HANS ) and Starbucks (Nasdaq: SBUX ) are pretty similar to those offered by competitors. But consumers continue to choose these companies' concoctions over cheaper alternatives due to the power of the companies' brands.
4. High switching costs
You know a company has a wide moat when its customers stick around year after year -- even if they hate the product! For years, users have complained about Microsoft's software, yet most of the wired world runs on Microsoft products.
The reason is simple: It would be an enormous effort to retrain employees and transfer files to a new format. And besides, everyone else uses Microsoft's software, too. Talk about a network effect!
Finding a company with a wide and sustainable moat is a good start, but that's not enough to produce long-term market-beating returns. A bargain price is always imperative, as are some things Fool co-founders David and Tom Gardner search for in their Motley Fool Stock Advisor service: wide-moat companies with strong balance sheets, dedicated and shareholder-friendly management, and wide market opportunities.
This strategy has helped the two brothers pick stocks that have returned 58% on average over the past five-plus years, versus 20% for like amounts invested in the S&P 500. To see all of David and Tom's recommendations, browse through their complete archives, and check out the network effects of our discussion boards firsthand, try Stock Advisor free for 30 days. There is no obligation to subscribe.
This article was originally published Jan. 15, 2008. It has been updated.
Fool contributor Rich Greifner has always found inspiration in the music of Sir Mix-a-Lot. Rich owns Mix's Return of the Bumpasaurus album, as well as shares of Starbucks. The Motley Fool owns shares of Starbucks. Discover, Microsoft, and Starbucks are Inside Value recommendations. Starbucks and eBay are Stock Advisor selections, while Dell is a former Stock Advisor recommendation. GlaxoSmithKline is an Income Investor pick. The Fool has a disclosure policy.