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Why You Should Invest in Moats

An economic moat can be the difference between a company that soars and one that stumbles or fails completely. Here’s why you should add some stocks with moats to your portfolio.

A Castle with a Moat

“In business, I look for economic castles protected by unbreachable moats.”

-Warren Buffett

Warren Buffett is always looking for companies with economic moats: Stocks that have some defense against competitors encroaching upon their customers and profits. A lead in the marketplace is important, but a moat to keep rivals at bay is the key to an enduring run by a growth stock.

Moats come in many forms. Consider the much-maligned social media companies X (formerly Twitter) and Facebook: their moats are their audience size; despite major miscues by each company, users remain on those platforms because that’s where all the other users are.

Or, think about the countless mom-and-pop grocery stores that struggled and ultimately failed when Walmart came to town. Customer loyalty aside, these companies had no economic moats to defend against Walmart’s low prices and broad array of product offerings.

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 buying moat stocks, i.e., picking companies with a built-in advantage giving them above-average profits for as long as possible.

This is important because in a free-market economy, like a hungry tiger, capital hunts for 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 moat is its dominant dealer network. The liquidity and the closed network of futures exchanges like the Chicago Mercantile Exchange lead to high levels of consistent profitability.

The world’s largest producer of paper pulp is based in Brazil because seedlings mature in the temperate climate of Brazil more than twice as fast as in North America.

Absolute size and scale are important and the key reason for Exxon Mobil stock’s stellar performance with margins in refining and chemicals dwarfing the competition. Ditto for China’s dominance in processing commodities from copper to rare earths.

Invesco’s QQQ Trust (QQQ) doesn’t quite have a monopoly on tech ETFs but it is a brand that is synonymous with tech investing and jumped with Nvidia’s quarterly report. QQQ has nearly doubled S&P 500 returns over the last decade. This $200 billion exchange-traded fund was created in 1999 by Nasdaq and is now the fifth largest ETF by assets.

An easy way to get some moat stocks into your portfolio is with the Van Eck Moat ETF (MOAT). MOAT is a basket of moat stocks trading at relatively low valuations according to a Morningstar model. It is up about 19% so far this year.

The top four holdings of this ETF are Domino’s Pizza (DPZ), Alphabet (GOOGL), TransUnion (TRU) and Polaris (PII).

The Cabot Explorer, just last month, recommended a stock that has both a wide moat and quasi-monopoly power. During its latest quarter, the company processed a total of 54 billion transactions across the world and continues to reward shareholders generously, with $3.9 billion returned during the quarter in the form of dividends and stock repurchases.

Find out more about this company and stock by joining the Cabot Explorer today.

Carl Delfeld is a member of the Cabot investment team, and chief analyst of Cabot Explorer.