Set 'Em and (Possibly) Forget 'Em

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"In business, I look for economic castles protected by unbreachable 'moats'," said Warren Buffett in 1995. Thus, a cliche and a cause were born.

Buffett referred to companies with some special advantage that buttresses them against competitors, economic ups and downs, and incompetent management. At least, that's my interpretation.

Morningstar offered four situations most likely to engender unbreachable moats: 

1. Low-cost producer (a company exhibiting a cost-advantage over the competition)
2. High switching costs (products requiring a commitment from the user)
3. The network effect (companies providing a central station for networking, buying, and selling)
4. Intangible assets (patents, trademarks, and brands)

Waterless moats
It all sounds fine and dandy in theory, until you realize how subjective the moat concept actually is -- and worse, how illusory a moat can be. History is replete with examples of companies supposedly blessed with unbreachable moats suddenly confronted with competitors and other outside forces storming the Bastille.

In the late 1990s, few moats were considered less traversable than Microsoft's (Nasdaq: MSFT) and Dell Computer's (Nasdaq: DELL). (Morningstar uses Dell as an example of low-cost producer moat.) Dell revolutionized the computer-purchasing experience with its online-only distribution model, while Microsoft's operating systems powered virtually all the personal computers Dell and everyone else sold.

But times change, especially in technology. In 2009, this article was written on a $200 mail-ordered Everex desktop computer (bye-bye Dell's economic moat) powered by a free Linux-based Ubuntu operating system and OpenOffice.org application software (so long Microsoft's). Yes, Dell and Microsoft still sell a lot of product, but not as much as they used to. In fact, both companies posted year-over-year revenue declines in 2009.

Plain, simple ... and well-advertised
With all due respect to Morningstar, I think the moat concept should be expanded to exclude sectors that my investing experience suggests will always be moatless, however moat-endowed they may appear at the time. Sit-down restaurants and specialty retailers are always vulnerable because of ease of entry, high-employee turnover, and consumer fickleness. How can a company dig a moat in the airline industry, where high fixed costs prevail and bankrupt competitors set the marginal price? And technology? Innovation is rarely the domain of a company saddled with legacy costs.

My experience also suggests moats, or at least semblances of moats, are the province of simple, commoditized, yet heavily and cleverly advertised sectors, where there is little else to distinguish one brand from the other except adverting.

Don't underestimate the power of advertising; it can create a visceral, unbreakable emotional bond with consumers. You cross such bonds in industries where the principal product is inhaled, imbibed, or ingested. The following companies produce food, beverage, or tobacco commodity products, and you would be hard-pressed to find businesses with greater brand loyalty:

Company	Leading Brand
Philip Morris International (NYSE: PM)	Marlboro
Coca-Cola (NYSE: KO)	Eponymous cola
McDonald's (NYSE: MCD)	Big Mac
Anheuser-Busch InBev (NYSE: BUD)	Budweiser
H.J. Heinz (NYSE: HNZ)	Eponymous ketchup

These comapnies fill their moats with tobacco, flavored sugar water, ground beef, beer, and processed tomatoes. Too pedestrian, you might argue, but I would counter that chances are good that every one of these companies -- or at least their leading brands -- will exist 50 years from now. I'm hesitant to say the same for Dell or Microsoft and their leading brands.

Pray for a misstep
Of course, nothing is assured. Over time, perceived moats generate attention; their mere existence doesn't guarantee investing success. The pool of investors seeking the highest-quality stocks quickly fills to overflowing. Reward is limited because prices are bid to eye-level. In other words, price matters. Philip Morris, Coke, AB-InBev, McDonald's, and Heinz all boast wonderfully sturdy brands, to be sure, but who doesn't know that?  

What's more, moat-blessed companies, despite their superior market position, aren't immune to costly missteps. Two of the more egregious examples are Philip Morris and "Marlboro Friday," and Coca-Cola and New Coke. The good news is that missteps create opportunity; unbreakable bonds are sturdy by nature, as Philip Morris and Coca-Cola have proven. So the next time Philip Morris, Coke, McDonald's, AB-InBev, or Heinz misstep, you might consider stepping in. Once you do, you might never have to consider stepping out.