Warren Buffett once said that he likes to invest in businesses with “economic castles protected by unbreachable moats”. He was referring to firms that boast a fundamental competitive edge over their rivals, a structural advantage that should allow them to keep raking in profits for a long time; companies that could turn a profit “even with a monkey running them”, says Mark Sellers on Morningstar.com.
Which types of stocks offer most security?
One such economic moat is a huge market share based on economies of scale, which makes it difficult for competitors to catch up. Witness Wal-Mart and Tesco’s buying power. The advantage of economies of scale can also be seen in companies benefiting from the network effect. This is often exploited by the first mover in an emerging field, such as Ebay in online auctions. More buyers entice more sellers, and so on. Low-cost producers in commoditised industries, such as airlines, have wide moats, says Sellers – America’s Southwest Airlines is often cited in this context. Moats can also be based on intangible assets, such as a strong brand name, patents, or regulatory protection – all of which can create high barriers to entry for potential competitors. Nick Louth in Investors Chronicle highlights geographical monopolies such as BAA’s virtual stanglehold over London airports, or Forth Ports’ control of shipping access to Edinburgh, as especially durable in this regard.
Extraordinary stocks to consider
An “extraordinary” stock highlighted by Louth is Genus (GNS, 511p), the global leader in a niche with “enormous technological and reputational barriers to entry”. It is in the business of cross-breeding livestock, and its “patented technology and proprietary lines of breeding animals” offer farmers higher milk yields and higher-quality meat. It looks appealing on a forward p/e of 18. Consider also BT (BT.A, 291p), which owns the wires that connect most UK homes to the local telephone network. Rivals can rent these for a fee, but BT still boasts a profitable customer base made up of those who “cannot be bothered to switch” to other providers now that broadband internet is available through the local loops. The cash thus generated is allowing BT to compete in other areas. The stock is on a “modest” forward p/e of 13 and a forward yield of almost 5%. Social housing services provider Connaught (CNT, 283p), which has established a reputation for top-notch service, is also worth a look.