“In business, I look for economic castles protected by unbreachable moats.”
—Warren Buffet
As wildfires this summer threatened homes in Canada, Europe, and America, many homeowners actually thought about building a moat around their property. This is not a bad idea, and I wondered if we all might benefit from building a moat around our portfolios, especially in this time of high valuations and global turbulence.
The moat concept can be applied to stocks that are, after all, a piece of a business. Any lasting competitive advantage that allows a company to earn above-average returns over a long period of time is a moat.
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For Oracle, clients considering moving away from its databases would face high costs and turmoil. Coca-Cola’s unimaginable scale and brand power (in every country but North Korea and Cuba) give it premium-pricing power. UPS delivery by ground leads to low capital costs and high returns, while FedEx is the opposite due to a reliance on air delivery.
The concept of economic moats is the primary theme of a great book by Pat Dorsey called The Little Book That Builds Wealth. Dorsey defines an economic moat as a durable competitive advantage that allows a firm to earn above-average returns on capital over a long period of time.
Since investing in a share of a stock is buying a small piece of a business, successful investing involves picking companies with built-in advantages that give them above-average profits for as long as possible.
This is important because in a free-market economy, capital seeks the areas of highest return. Whenever a company develops a profitable product or service, it doesn’t take long before competitive forces drive down its economic profits. Only companies with an economic moat can hold competitors at bay and generate economic profits over an extended period.
In his book, Dorsey explains that Deere & Company’s (DE) moat is its dominant dealer network and that the liquidity and the closed network of futures exchanges like the Chicago Mercantile Exchange led to high levels of consistent profitability. Other companies benefit from cost and logistical advantages. Compass Minerals’ (CMP) edge in the rock salt business is the lowest-cost mine in the world in Ontario and its proximity to waterways to key Midwestern markets.
Absolute size and scale are also important and key reasons for Exxon Mobil’s (XOM) stellar performance, with margins in refining and chemicals dwarfing the competition.
An easy way to get some moat stocks into your portfolio is with the VanEck Moat ETF (MOAT). MOAT is a basket of 20 moat stocks trading at the lowest valuation according to a Morningstar model. It is up 17.6% over the last year.
For your core portfolio, a basket of value moat stocks will help you outperform the market with lower volatility.
The only thing better than a moat stock is a speculative stock on its way to becoming a moat stock.
An example of this would have been Palantir Technologies (PLTR). Wall Street long labeled Palantir as a highly speculative, cash-burning black box reliant on government contracts. However, the company has spent recent years systematically building a massive economic moat centered on high switching costs and data integration. Over time, Palantir’s Foundry Artificial Intelligence Platform software has become the operational central nervous system for corporations and governments.
Palantir was a Cabot Explorer stock recommendation. For more moat stocks and other exciting opportunities, join the Explorer today as we search the world for the best stock ideas.
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