Knowing what features of great companies to look for can really demystify the investment process. What's the special sauce that makes a company great? Is it a passionate leader? A hot brand? The CEO with the biggest yacht?
Morningstar's director of equity research, Pat Dorsey, lays out the bread crumbs on the path toward market-beating returns in his recent book, The Little Book That Builds Wealth.
The most important thing to look for comes straight out of the Warren Buffett playbook: economic moats. A wide, deep moat acts like an impenetrable barrier to keep invading competitors at bay. Economic moats are competitive advantages that allow a company to sustain high returns on capital for very long periods of time. A portfolio of these types of companies will give investors a great chance of achieving investment success.
As with anything in life, there are no guarantees, but investing in these types of companies tilts the odds in your favor. This is the central tenet of Dorsey's book.
So what are economic moats? According to Dorsey, they are:
- Intangible assets like patents or brands
- Network economics
- High customer switching costs
- Cost advantages
Dorsey's list serves as a great starting point of things to look for in your research. Here are some examples to help get you started:
Intangible assets
Not all patents are created equal. In other words, just because a company has patents on its products or processes doesn't necessarily mean the company has a durable competitive advantage. Consider, for example, the biologic drugs (produced from lab cultures) sold by biotech companies like Amgen (Nasdaq: AMGN) and Genzyme (Nasdaq: GENZ) versus the synthetic drugs sold by Pfizer (NYSE: PFE).
Many of Pfizer's drug patents will expire within the next five years -- and take $20 billion in revenue along with them. In other words, these drugs have a fleeting competitive advantage, but not a durable one.
The biotech companies are in a much stronger position, because their drugs are less susceptible to generic knockoffs, both technically and legally. At this time, there isn't even a regulatory mechanism in place to get generic copies approved by the FDA and to the market. This gives companies with these types of drugs a tremendous moat and a very durable stream of cash flows.
Network economics
The textbook example of network economics is eBay (Nasdaq: EBAY) and its dominance in online auctions, at least in the United States. A business can be described as having network effects when the strength and value of its network increases with more participants. eBay is the go-to destination for online auctions. Anyone looking to buy or sell a Tom Gardner bobblehead doll is going to go to its site.
Network effects are so severe in this business that eBay itself has had tremendous difficulty exporting its success into Asia. The company is bleeding market share to Gmarket (Nasdaq: GMKT) in South Korea, and even a strategic partnership with Baidu.com (Nasdaq: BIDU) hasn't helped it to compete with the Yahoo! (Nasdaq: YHOO)-Alibaba duo in China.
I think there's a higher chance I'll get struck by lightning than that another company will exactly replicate eBay's model in the U.S. and breach its moat. That said, investors must remain vigilant to make sure that competitors aren't drilling up from underneath to drain all the water out. eBay's moat is susceptible to competition from other types of e-commerce -- and I'm not referring to the usual suspects like Amazon.com, but to niche sites that serve a very specific customer extremely well. This can be a site like electronics purveyor Newegg, where you can find an abundance of informed customer reviews and a layout which quickly leads you to exactly what you want.
The Foolish bottom line
At the end of the day, sound investment decisions come down to a few key variables. Find companies with economic moats, learn about their businesses and industry, and determine how long their advantage can last. The longer a company can do something that no one else can do, the stronger the business. Typically, these companies can generate high returns on invested capital for many years, increasing the company's value -- and the price of your shares along with it.
If you're looking for companies with strong and durable moats, consider Motley Fool Million Dollar Portfolio, the new offering I work on with Fool co-founder Tom Gardner. You'll get an all-access pass to follow along as Tom and our team invest $1 million of the Fool's own money in recommendations from across our premium services. To learn more about Million Dollar Portfolio, just click here for all the details.
Million Dollar Portfolio associate advisor Charly Travers owns lots of books, but no shares of any company mentioned in this article. The Motley Fool owns shares of Morningstar. Pfizer is a recommendation of our Income Investor and Inside Value services. Amazon, Morningstar, and eBay are Stock Advisor selections. Baidu and Gmarket are Rule Breakers recommendations. The Fool's disclosure policy fits more snugly than Robert Plant's pants.
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