When picking stocks for long-term investments, you want to pick a company that will continue to stomp on its competition in the future. You don't want to pick a company that is here today, but will be gone tomorrow. With that in mind, let's take a look at some software companies to find the key ingredients in selecting a stock that has "staying power" thanks to its economic moat.
Economic moats
You may remember moats from history or from medieval movies as deep, broad ditches (often filled with water) that were used as a defensive mechanism for a castle. While an actual moat won't keep competitors at bay in today's business world, a company can create an economic moat capable of fending off marauding rivals bent on taking market share and profits. Though this economic moat may not be tangible and hence not nearly as cool as an actual water-filled moat surrounding a castle, it can be just as effective in protecting a business.
So what exactly constitutes an economic moat? Well, as defined by legendary investor Warren Buffett, it can be just about anything that allows a company to maintain its competitive advantage. For example, an economic moat can be anything from Wal-Mart's (NYSE: WMT) access to low-cost supplies or patent protection on Pfizer's (NYSE: PFE) drug Lipitor. In the software industry, companies typically establish this through intellectual property rights (patents and copyrights), high-switching costs (difficult or costly to switch products), and the network effect (everyone is using the same product). These tactics prevent competitors from taking customers or eroding a company's pricing power, hence a moat is figuratively created around the company.
What to look for
Now that you understand what an economic moat is, how do you determine if a company has established one? Unfortunately, determining if an economic moat exists is not a simple task. Economic moats are qualitative in nature, but there are signs that can be a useful guide to identifying them. Looking at companies like Microsoft (Nasdaq: MSFT), Oracle (Nasdaq: ORCL), Intuit (Nasdaq: INTU), and Dassault Systemes, we can establish some telltale signs of an economic moat.
One sign is that a company's brand is well-established and is likely to continue to be popular. Take Microsoft. Consumers and businesses are all familiar with Microsoft's Windows operating systems. While there is argument on whether or not it is the best operating system available, there is no debate that the Windows brand is here to stay for the foreseeable future. Not only is it protected by patents and trademarks, but it is expensive to switch systems (high switching costs) and there are benefits in technological capability to having most people using the same system (network effect). To a large extent, similar statements can be said of Oracle's database software, Intuit's QuickBooks software, and Dassault's Solidworks product design software. Though brand names come and go, it will be difficult for opponents to overcome these advantages.
Another indictor of a sustainable moat is a history of strong financial results. The key here is looking at profitability. If a company has a moat that keeps competitors out, then it should be very profitable over a long time. Microsoft, Oracle, Intuit, and Dassault Systemes have consistently earned high returns on equity as measured by the return-on-equity (ROE) ratio. This is a good indication that these companies are able to generate strong profits while their rivals are left in the dark.
Moats decrease risk but not returns
While an economic moat ensures that your stock has staying power, it does not guarantee a handsome payoff in the software realm. Microsoft, Oracle, and Dassault Systemes have all performed very closely to the benchmark S&P 500 over the past 10 years. Though many factors have contributed to the performance of these stocks, having a strong moat may be more useful for protecting against poor returns than in identifying the next stock that will make you rich.
Thinking about moats may not make you the next billionaire, but it certainly won't bleed you dry, either. So if you're looking to squeeze a little more return from your portfolio, without adding to risk, then you should start thinking about defensive positioning. A little defense can go a long ways over an investing lifetime.
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