Economic moats are no secret, but they remain an underrated angle for long-term investing. Here are three best bets for 2015.
What is a moat?
In investing, an economic moat is a fancy term for sustainable competitive advantages.
So, what are the advantages of economic moats? Basically, a company with a moat can earn an above average rate of return over an extended period of time. Or, more broadly, investors can think of moats as advantages that keep a company’s returns from diminishing.
Even for great businesses, competitive advantages seem diminish over time without a moat. Think of Blockbuster and Dell, both strong businesses that ultimately went into steep decline.
For long-term investors, economic moats can be very important.
Famed billionaire Warren Buffett has said, “In business, I look for economic castles protected by unbreachable ‘moats’.”
And while large market share, a great CEO and impressive technology are all advantages, they aren’t necessarily sustainable. But one thing is true: moats come in all shapes and sizes.
Wal-Mart Stores (NYSE: WMT) has a moat given its large scale, which gives the company cost advantages—whereby it can undercut the competition. High switching costs are interesting as well; this moat is usually present in large companies like Oracle (NASDAQ: ORCL). In Oracle’s case, switching away from its databases can be costly and cumbersome.
There are also intangibles, which range from patents to brand recognition. And customer loyalty can’t be stressed enough. Apple (NASDAQ: AAPL) has been a big benefactor of brand loyalty over the last decade. Also, consider one of Warren Buffett’s biggest investments, Coca-Cola (NYSE: KO). Its moat lies in brand loyalty and name recognition.
Then there are network effects, where a strong network becomes more useful and powerful as more people join. Think of eBay (NASDAQ: EBAY), which has over 150 million active buyers. More buyers on the site is great news for sellers, and more sellers is great for buyers.
So how do we measure a moat? That’s an inexact science, but the sustained competitive advantages can be seen with sustained high returns on invested capital. High returns imply that a company is keeping competitors in check.
Along those lines, it appears eBay might be losing its dominance, where its ROIC has been in decline over the last couple years.
However, the three stocks below have maintained their solid returns on invested capital and should continue to dominate their respective markets in 2015.
Economic Moat to Own for 2015 No. 1: Google (NASDAQ: GOOG)
Google has one of the best moats in the technology space. The name alone now has a loyal following; Googling has become synonymous with Internet searching.
While Google isn’t the only search game in town, where there’s Microsoft’s (NASDAQ: MSFT) Bing and Yahoo! (NASDAQ: YHOO), cost in and of itself is a moat for Google. Search is free and Google is the market share leader so there’s little benefit to consumers for using another player.
Google is also great at tapping adjacent markets. It started its move to mobile long ago with its Android mobile operating system. That enabled it to lock up market share in the mobile search market.
Google can retain its moats going forward too, because it never settles. It has a focus on innovation, where it continues to launch new products and services in an effort to broaden its reach. And the tech giant has the cash hoard to keep this up.
Economic Moat to Own for 2015 No. 2: MasterCard (NYSE: MA)
MasterCard has been one of the biggest benefactors of the shift away from cash and checks and toward card payments. Its moat lies in its network effect, in which it has built a network that’s widely accepted by merchants across the world. Meanwhile, its card is widely used; making its platform a win-win for users and merchants.
Beyond just processing card payments, MasterCard has been actively growing its presence in emerging markets and tapping the exciting mobile payment market. The other beauty to MasterCard is that it’s generating a very impressive 40% plus return on invested capital —and has been for a number of years.
Economic Moat to Own for 2015 No. 3: Union Pacific (NYSE: UNP)
A bit of a change of pace, but this 150-year-old railroad company one of the best moats around. Union Pacific’s network of rail track can’t be replicated. What’s more is that railroad operators are major players in the economic cycle. Union Pacific is benefiting from a rebound in the housing recovery and imported beer delivery, among other things.
Overall, railroad operators have vast infrastructure and network scale that adds to cost advantages — compared to other forms of transportation like trucking or air. Union Pacific has seen its margins expand nicely over the last decade and its return on invested capital has also steadily risen over this time —now up to 15%.
I’ll leave you with this: If you’re a true long-term investor, one of the best things you can do is focus on companies with a moat. A wide moat greatly reduces the chance that a new technology will make your company obsolete overnight.
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