The Importance of Economic Moats

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The Importance of Economic Moats

Michael Porter’s framework of five forces from his book Competitive Strategy makes scouring an industry for great investment ideas much easier. Understanding an industry helps us find the great businesses with economic moats that will withstand the inevitable economic, competitive, and random other challenges that often cripple weaker businesses.

Recall that a moat is the competitive advantage that one company has over other companies in its industry.

Once we have a collection of great businesses from which to choose, finding those that meet our criteria and deliver above-average returns on invested capital over the long term becomes even easier.

A word to the wise regarding moats

Generally, it is commonly advised that investors should steer clear of companies that have no moat (Morningstar gives them a moat rating of "none") because they have very few, if any, competitive advantages and can’t keep rivals from eating away at their profits. (Lots of these companies don’t even have any profits.) More than likely, one wouldn’t want to hold a no-moat company for the long haul, so one probably wouldn’t buy stock in one of these firms to begin with.

Some people are shrewd enough to buy no-moat stocks on a dip, hold them for a short term, and make a profit. For long-term investors, this isn’t a game they like to play. Generally, the rewards are far higher, and the risks much lower, for those who spend a little effort to find strong companies to hold for a long time.