Security Analysis 301: Look for a Wide Moat

In my article "Security Analysis 101," I suggested that you need to understand the importance of identifying a margin of safety when you examine potential investments. Ultimately, you have to be able to differentiate between value and price. Price is what you pay, and value is what you get.

Then, in "Security Analysis 201," I shifted my focus to explaining why intrinsic value is a central concept to valuing a business -- namely, determining a company's intrinsic value also determines your margin of safety, and the wider the margin of safety, the better. A company's intrinsic value is an estimate, and your estimate gets better with the more inputs you have.

Since calculating an intrinsic value involves predicting future cash flows, you need to have some reasonable confidence in the future earnings growth of a business. For earnings to grow, a company needs to increase revenue and at least maintain costs. And for the most part, increased earnings should lead to increased cash flows in the long run. Don't spend a lot of time looking at one-time quarterly charges and the like when you're looking for increased cash flows. Instead, you might want to look at annual cash flow statements for signs of a good, healthy increase in the rate of cash flow growth.

Businesses that have competitive advantages or wide moats around them usually throw off tons of cash, and they allow you to predict future cash flows with a higher degree of certainty. Those are the companies we want to consider today.

Focus on the moats
Once you find an attractive business that you understand, you need to determine whether the business has staying power or is under constant threat from new entrants. An investment approach that focuses on investing in wide-moat businesses and avoiding the no-moat businesses will produce satisfactory long-term results.

The definition of a great business with a wide moat is one that has at least some of the following characteristics:

  • Recurring revenue streams.
  • Ability to produce at low costs.
  • A monopoly or oligopoly type of market positioning.
  • A strong franchise or brand that gives the company insulation from most of the competition.
  • Ability to raise prices ahead of inflation.

Let's look at some businesses that have one or more of these characteristics.

So easy, a caveman could do it
Insurance companies take in a lot of premiums up front and pay out claims at a later date. Find an insurance business that masters the art of taking in the most and paying out the least, and you have yourself a wonderful business. Berkshire Hathaway's (NYSE: BRK-A  ) (NYSE: BRK-B  ) Warren Buffett knew that when he found GEICO. He wrote an article about the company, titled "The Security I Like Best," when he was 21 -- long before he bought it. Even then, Buffett saw that GEICO had a recurring revenue stream that would never go away as long as humans use cars.

By insuring drivers all over the country, GEICO naturally shields itself from the risk of being geographically concentrated. It also has a history of insuring the best drivers, so its claims payout is low. That means GEICO can lower its premium, which it does. And that gives the company a good, wide moat.

Monopolistic market share
Companies that dominate their industry tend to do quite well over the long run. American Express (NYSE: AXP  ) is a wonderful example of a business operating in a monopolistic type of industry. For decades, credit cards and travelers' checks were synonymous with AmEx, and if you look at the company today, you can still find tons of cash generation. Home Depot (NYSE: HD  ) and Lowe's (NYSE: LOW  ) are other great examples of businesses that own their industry. Without exception, all three of these businesses have rewarded people who have invested in them for the long term.

The real thing
There is no better model for brand value than Coca-Cola (NYSE: KO  ) . The iconic red can is recognized the world over. You don't see too many businesses looking to start new soft-drink companies, and even if there were one, I don't think any amount of money could ever topple the  Coke brand. Buffett realized that the intangible value of that brand was indeed very valuable, and so he bet big in the 1980s. A good brand like this is virtually indestructible, and over time, the moat just gets wider and wider.

While the best returns may have already come and gone for businesses such as Coke and Home Depot, capitalism never fails to produce a new crop of companies in industries that could become the next investment of the same caliber. Great investments like this aren't easy to find. But with the recent market turmoil, a lot of undeniably excellent businesses have suffered unjustifiable declines in price, so this is a perfect time to go prospecting for the next multibaggers, at the very least.

A final look back
Give yourself a pat on the back if you noticed a common theme in the businesses I've discussed here: Buffett has substantially invested in most of them. It's not a coincidence that the world's greatest investor invests big in businesses that have wide moats.

Related Foolishness:

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Fool contributor Sham Gad runs the Gad Partners Funds, a value-centric investment partnership modeled after the 1950s Buffett Partnerships. He owns a stake in Berkshire Hathaway, which is a recommendation in Inside Value and Stock Advisor. Reach him at shammf@gmail.com. The Fool's disclosure policy is designed for safety.


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