It’s nearly impossible not to pay attention to words of wisdom when it’s coming from the likes of Warren Buffett.
Whether it’s when he’s addressing thousands of his investors, or participating in a quick interview – ignoring his advice just might cost you dearly.
For example, following his advice could have made you $12 million between 1964 and 2015.
Had you invested $1,000 in his Berkshire Hathaway Class-A shares in 1964 at just $19 a share you’d have realized gains of nearly $12 million by the start of 2015. Granted, some of us were still in diapers in 1964, but my point is easy to understand. Warren Buffett’s advice is well worth listening to.
And, oftentimes, his investment advice is simple to understand.
You don’t have to be an all-knowing financial expert. Instead, you must real that to make money you have to buy and hold growing companies that are relatively easy to understand.
For Buffett, to invest in a company, he must fully understand the nuts and bolts of a company. It must be simple for him to break down and comprehend all the moving parts.
That may help explain why his portfolio has more consumer related stocks than biotech or technology. He’s also looking for a healthy stream of earnings, as well as a stock that can be bought at a reasonable price.
However, one of his greatest metrics for identifying gems is his rule of identifying a company’s “economic moat.”
"A truly great business must have an enduring "moat" that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business "castle" that is earning high returns,” Buffett was quoted by Townhall Finance.
"Therefore a formidable barrier such as a company's being the low-cost producer or possessing a powerful world-wide brand is essential for sustained success. Business history is filled with "Roman Candles," companies whose moats proved illusory and were soon crossed."
A strong “moat” doesn’t just refer to what Warren Buffett wants to see. It’s also a way to view your own operations for continued success.
In defining economic moat a bit better, here is a simple question. If I handed you $50 billion and asked you to replicate Apple, Microsoft, even Starbucks, could you do it successfully?
For most of us the answer is no. And that’s because those companies have a wide-reaching protective moat. Because they have such a moat, they can protect long-term profits and market share from other competitors trying to weigh in.
Understand moat, and you stand to increase your odds of longer-term success.
As Buffett has famously noted, in business, “I look for economic castles protected by unbreachable moats…”
For an entrepreneur, creating a moat involves a multi-step process of asking what the new mega-trends are, or what’s beginning to appear on radar. Are there barriers to entry for new emerging moats? Is there an attractive market that can be improved upon, or are there markets that can be tapped into where there is unmet demand?
Traits of a powerful moat
A moat is what allows a company to protect itself from its competition. It allows a company to do what its competitors cannot do – like charge a 400% premium for coffee, as Starbucks can do – even though you can buy coffee for $2 at a local mom and pop.
For example, Sony once had a stranglehold on the portable music business. It lost that moat to Apple. It’s nearly impossible to name a music device that isn’t an iPad these days.
Blockbuster lost its moat to Netflix and RedBox.
A successful moat consists of a strong brand name
When you think of coffee, many of us think of Starbucks immediately. It has a powerful brand with incredibly loyal customers that pay more than a 300% premium for coffee. Coca-Cola is one of the most dominant names on the planet that can overpower its competition.
Strong brands drive sales, market values, and eventually shareholder value. It’s tough to penetrate a thick moat when the brand is strong.
Switching costs can be too high
At one time, about 70 percent of computers ran Windows. Thirty years after launch, Microsoft was generating $18 billion in revenue from the operating system. It enjoyed that because of its moat, strengthened by switching costs.
The gains of using any other product are far outweighed by the “switching costs.” If I wanted to switch from Apple to Microsoft, for example, after years of loving my Mac, I would have to buy a new computer, new software programs, and spend the time to relearn everything I already became comfortable with my Mac. In short, sometimes, it’s just not worth the hassle because the overall ‘emotional and monetary’ costs are too high.
There is network effect
Facebook and Twitter have a network effect that’s not easy to replicate. Even eBay has this effect, cornering the online auction market. Sellers and buyers use the site to network with millions of other buyers and sellers. Based on the network effect of eBay, it’s nearly impossible to penetrate that moat, or disrupt their revenue stream.
There are lower- cost providers
Inspired by the success of a dime store he once owned, Sam Walton would open the first WalMart in 1962 in Rogers, Arkansas. Competitors thought the idea of offering lower prices and better value would never work. Eight years later, Walton began to expand outside of Arkansas. By 1970, 38 stores were opened with $44.2 million in sales.
By 1990, after a great deal of hard work and determination, the discount retailer would become the top retailer in the U.S. with $26 billion in sales. The company is now worth well over $223.5 billion, crushing most of its competitors with lower cost goods. The ability to offer good products at lower costs is why the company has become a multi-billion dollar retail behemoth. It can’t be touched.
It has intangible assets
And finally, there are some companies that have a powerful advantage over others because of intangible assets, including patents, licenses, and brand recognition. If a company’s product is protected with a patent, it’s tough to replicate. A pharmaceutical company can pay top dividends to investors thanks to patents on top-selling drugs, which can crush competitors. While such companies have a protective moat, the potential loss of patent protection on some drugs can make companies a bit nervous.
While the practice of identifying moat has made Warren Buffett and smart investors a great deal of money, such knowledge can also help in the development of a new entrepreneurial idea. Keep these things in mind as you develop your ideas.
You never know. Perhaps you could develop something with an impenetrable moat, too. Remember, Starbucks was once a startup developed by three teachers for a little more than $4,000. It’s now an $80 billion company with a wide-reaching moat.