The Key to Investing

If you look up Tom Gardner's online profile, he describes his investing style as looking for "moat diggers." That style has worked out very well for him and his Hidden Gems subscribers, but what does he mean? And can you find "moat digging" companies all on your own?

Well, sure you can.

For some insight on what it means to look for moat-digging companies, let's dip into the near-bottomless pool of wisdom that Warren Buffett has provided us over the years, and extract one of his best quotes, this one from the Nov. 22, 1999, issue of Fortune:

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.

Recall the timing of those words -- this was the bubble era. Investors were flocking to put huge amounts of money into Internet companies. Some, such as eBay (Nasdaq: EBAY  ) and Dell (Nasdaq: DELL  ) , certainly had competitive moats (thanks to network effects and distribution and supply advantages, respectively) -- even if their valuations got ahead of themselves.

But those early days of the Internet were heady ones with great promise for revolutionary technologies, and investors clearly weren't concentrating on moat diggers. They also put a lot in far iffier operations, such as TheGlobe.com, seemingly without much discernment as to what long-term competitive advantages and protections to those advantages any of the companies had. And while eBay and Dell have had disappointing returns since the turn of the century, the businesses are strong and investors have not even come close to losing everything.

Why? Moats.

Moats matter
Any business that produces impressive returns is going to attract more than just eager investors; it's going to attract competitors. Whenever someone is making piles of money, others will try to figure out a way to their own piece of the action.

That's where the concept of Buffett's moat comes in. A moat is some aspect of a business that keeps competitors from storming the company's castle and making off with the treasure. When you're looking at any company that has delightful financial results and you're considering investing in it, you need to ask yourself not only how much those profits will grow, but if they might not evaporate entirely. You need to ascertain what's defending those profits -- what the moat is.

This is particularly important if you're interested in the substantial rewards of small-cap investing, as we are in our Hidden Gems service.

Model moats
Let's take a deeper look at three different types of moats that can protect a company's competitive advantage, even if you're investing in smaller companies.

1. Market share
Having a massive piece of the market is a great way to keep marauders at bay. It keeps costs low by giving the company economies of scale. Without similar scale, a new competitor will have a hard time delivering a product or service at a competitive price point. Consider the Microsoft (Nasdaq: MSFT  ) and Apple (Nasdaq: AAPL  ) story, and how the first few chapters were defined by Microsoft's dominant market share of the operating system space, even though many have argued for years that Apple had a better product. Now, the shoe is on the other foot, with Apple's market share for MP3 players giving it an economic moat, despite serious competition from many -- including Microsoft.

It is unusual for a small cap to have a sizable market share of a large industry -- indeed, if one did, it would quickly become a large cap. But developing a huge market share for a niche or nascent market is more likely. Drew Industries (NYSE: DW  ) , for instance, has 70% of the recreation vehicle window and door market -- a niche that a much larger player isn't likely to go after. That helps explain how Drew has provided 2,390% returns to shareholders over the past 15 years.

2. Patents and licenses
Another moat is the legal protection of a product, in the form of patents, copyrights, or government approvals or licenses. While moats like this can ward off all competition, the problem in some cases is that they're temporary. Consider drug makers such as Bristol-Myers (NYSE: BMY  ) or Genentech (NYSE: DNA  ) -- the enormous profits for their blockbuster drugs are made possible by patent protection. But as soon as that protection expires, generic drugmakers swarm in to take a chunk of that high-margin revenue.

In the small-cap realm, there are plenty of drugmakers that through one or two protected drugs have an economic moat. But other forms of governmental protection have a small and temporary economic moat. Strayer Education, a for-profit education provider, has earned regional accreditation. Without accreditation, a degree is not worth as much. Since it takes a significant amount of time and resources to earn and maintain accreditation, meaningful competitors with Strayer cannot pop up overnight -- because without accreditation, their offerings would be less appealing.

3. Distribution and supply
A specialized distribution system can be an excellent moat. Like Dell, Coca-Cola is one of those companies that has created a moat through a superior distribution and supply operation.

Blue Nile, the leader in online diamond sales, is building a similar kind of moat. It has exclusive distribution agreements with many of its diamond suppliers. If a rival opts to take on Blue Nile and sell diamonds at an even lower price point, it can try. But without Blue Nile's access to the product, it will be hard to duplicate its prices.

Learn more
To learn about all kinds of economic moats, the ones that have provided Hidden Gems subscribers with returns of 53% versus S&P 500 returns of 22% over the same time period, join us today for a free no-risk 30-day guest pass. We're glad to help you learn how to find the companies with the widest moats.

Bill Barker owns shares of Drew Industries. Drew Industries and Blue Nile are Hidden Gems recommendations. Blue Nile is also a Rule Breakers pick. eBay and Dell are Stock Advisor recommendations. Dell, Microsoft, and Coca-Cola are Inside Value recommendations. The Motley Fool has a disclosure policy.


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