With an average historical return of 10% per year, investing in the S&P 500 has proven to be a smart way to build wealth over the long term. Buying index funds to match that broad market performance can be impactful -- even Warren Buffett thinks so.
But some people still want to buy individual stocks in the hopes of beating the market. Among them, long-term investors typically fall into two camps: value investors vs. growth investors.
But it doesn't matter which camp you fall into -- investors are best off if they look for an economic moat in every stock they're considering. Here's why.
The sign of a great company
Popularized by Warren Buffett, an economic moat refers to a sustainable competitive advantage that allows a company to financially outperform its rivals. Most businesses aren't that great and will fail given enough time. It's the truly exceptional ones that deserve your hard-earned dollars.
For investors who intend to hold their stocks for at least five to 10 years, identifying companies with economic moats is critical because it increases the likelihood they will lead their industries well into the future.
The five kinds of moats
There are five types of moats to familiarize yourself with:
- High switching costs: these arise when customers are locked into a particular company's product or service, whether on contractual terms or because it would be a headache to switch providers
- Intangible assets: a strong brand or patent can serve as potent tools in fending off the competition
- Network effects: this moat arises when a product or service grows more valuable with each additional user
- Superior cost structure: a business that is able to make products at a lower cost than rivals has an advantage in pricing and profitability
- Efficient scale: when markets can only grow so large, entrenched companies make the space unattractive for new entrants
It might take time studying a particular company to understand what sort of economic moat it has, if any. Taking a step back, investors can first identify industry-leading businesses -- chances are high such companies have some form of economic moat.
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The recipe for strong investment returns
To illustrate just how powerful a wide economic moat can be in driving strong stock returns, consider these examples.
First, look at Apple. Its device owners face high switching costs thanks to its powerful ecosystem that combines its popular hardware products with a wide-ranging suite of software and services. Shares of the tech titan have increased 900% in the last decade.
Nike and Starbucks have priceless intangible assets in their strong brands. They are household names across the globe, and consumers identify with their products, which has allowed them to charge premium prices and achieve high profitability. In the last 20 years, shares of both the athletic apparel giant and coffeehouse chain have risen more than 1,000%.
By operating two-sided payment platforms that connect cardholders with merchants, Visa and Mastercard have powerful network effects that underpin their businesses. Their operating margins are well in excess of 55%, and this has helped them produce tons of free cash flow over the years. Both have seen their stock prices soar in the last decade with Visa up about 380% and Mastercard up 490%.
When it comes to gaining a cost advantage, it's hard to ignore Tesla's standing in the auto industry. Legacy automakers like Ford and GM continue losing money in their electric vehicle (EV) segments. But thanks to its advanced manufacturing capabilities and huge lead in the industry, Tesla is firmly profitable. The EV pioneer has been one of the best stocks to own over the past decade with an approximately 1,900% gain.
Verizon Communications benefits from efficient scale due to the huge upfront investments needed to build out a national wireless network, as well as the difficulty wireless service providers have in differentiating themselves. While its share price returns might not be as attractive as those delivered by companies in other categories, mainly due to the lower growth opportunities in its saturated market, income-seeking investors might still find Verizon attractive to own. Its current dividend yield is over 8%.
It should now be clear just how big a role an economic moat can play in a company's long-term story, so keep them in mind the next time you go searching for a stock to buy.
