“We like stocks that generate high returns on invested capital, where there is a strong likelihood that they will continue to do so. I look at long-term competitive advantage and [whether] that’s something that’s enduring.” Warren Buffet
Warren Buffet and Charlie Munger - Buffer! - built one of the most successful investment track records of all time by sticking to the idea that well run companies with highly defensive competitive positions produce superior returns over the long term.
“Within the Buffer thesis, we actively seek out companies with incredibly strong and defensible market positions as we believe these characteristics make them attractive investment propositions with lower than average risk.” Pouneh Bligaard, Director, Head of Research, Thesis Portfolio.
This thesis is built around the ‘Economic Moat’ theory. It is all about the idea that identifying growth potential isn’t enough. In a capitalist system, areas of growth and high potential returns attract capital in the form of new competitors, so pretty quickly, you get to a situation where the sizeable profits you thought the company would enjoy from its growth are bid away as competition heats up. This is why, after identifying growth potential, the next step in finding great investments is to look at how a company can protect its market position from others.
In the medieval period, most castles and forts were surrounded by a deep channel or ‘moat’ filled with water to protect against invaders. The wider the moat, the more difficult it was to storm the castle. In the modern day, Buffet has used the analogy to explain how he identifies the most formidable companies, who are more certain to hold on to their profits and grow them, giving their investors years of compounded growth potential.
The moat he refers to is basically the sustainable, competitive advantages that protect a company and allow it to earn high profits and shield its market share, thus staying ahead of its rivals over a prolonged period. But why should we as investors care if the business has built this economic moat? Because companies with wide economic moats are not only more likely to survive over long periods, but also more likely to generate consistently high profits. According to Economic Moat theory, the presence and size of an economic moat correlates to a company’s ability to sustain long-term profitability.
However, not many companies enjoy these sustainable advantages, it’s actually quite rare. One of the principles of modern economics is that, given time, competition will erode any and all advantages enjoyed by a firm. For example, even if a company leverages its first-mover advantage to rake in profits, a host of new players will very soon try to duplicate operations or discover better operating methods, taking away this temporary advantage.
Measuring the actual size of the moat is difficult and often can’t be done mathematically. It’s more a framework to think through the durability of competitive advantage.
“For us, economic moat principles are a useful framework for assessing just how great a company is at staying ahead and continuing to grow. Companies within this thesis are those we have identified as enjoying these rare and more durable competitive advantages.” Pouneh Bligaard, Director, Head of Research, Thesis Portfolio.
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