Saturday, February 19, 2005

Saturday Special: Economic Moat

Economic Moat should always make your list of criteria when deciding what stocks to buy. Because let's face it, no matter how juicy a company's prospects look now, an emerging company could easily sideswipe them and steal customers, product ideas, and ultimately, market share. That is the thing with business--you just never know. It s a risk reward game ad infinitum, the paragon of uncertainty par excellence. Economic Moat can be described as a company's ability to ward off competition. Morningstar says that
a company's competitive advantage allows them to earn excess profits by creating an economic moat around their business. Think of a castle with a moat around it--the deeper the moat, the more protected the castle. The wider a company's moat, the longer we believe they will generate high returns on capital. These companies are likely to be superior investments because they're better insulated from the competition.
I alway use eBay as a strong example of economic moat. If you read Adam Cohen'sThe Perfect Store: Inside eBay--one hell of a good book, by the way--you'll see how well--especially in the company's first five years--eBay staved off competitive threats. eBay wasn't the first or only online auctioneer, but they WERE the only company to sustain customer loyalty and brand recognition while rivals mimicked their business model and democratic ethos to no avail. It is other things too, like how well management was able to forsee looming disasters, or how much they spent on Research & Development so that their idea pipeline never dried up. I know Warren Buffet invests in company's with strong moat, as does Peter Lynch. Nowadays, I look at a company like Google and I tell myself that all the investors locked up with shares are there because they believe
Google has the werewithal to one-up the competition as it nears the castle. The other half is there for the easy money.

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