Some of you may be like me waiting on the sideline for the next stock market pullback, before adding stocks to our long term portfolio. While we're waiting on the sidelines, we might as well make a list of the stocks we want to pick up on the next pullback. What are some potential stocks worth considering? For me, I like Warren Buffett's strategy of focusing on stocks with built-in economic moats. The wider a business' moat, the more likely it will stand the test of time. In this article, I will discuss five factors that help create an economic moat and highlight companies that benefit from these factors.
1) Rights of Way: Rights of way relate to legal rights that a company has obtained to operate their business in a location. For example, think about railroad operators such as Union Pacific (UNP), Norfolk Southern (NSC) and CSX Corp. (CSX). Railroad operators obtained rights of way to build and operate their railroad network across the country. It is extremely difficult for a new entrant (even if they are willing to invest significant upfront capital) to build a new railroad network, given would need to negotiate for new rights of way with numerous local municipalities and states that the railroad track would operate across. Buffett acquired railroad operator Burlington Northern Santa Fe for $16 billion in February 2010.
Besides railroad operators, waste management companies such as Waste Management (WM) and Republic Services (RSG) also have rights of way advantages. These companies own valuable landfill rights that have remaining lives of 40-50 years. In addition, the waste collection routes owned by these companies provide annuity like, recurring revenue streams. Buffett has owned Republic Services in the past, and Bill Gates (through Cascade Investments LLC) still owns a large percentage of Republic Services.
2) High-Switching Costs: If there are high switching costs, customers would need a significant improvement or cost saving to justify the cost of switching out of their existing product or service. For example, Buffett recently invested in IBM (IBM), which was a surprise given that Buffett stays away from investing in the tech sector. However, besides the shareholder friendly stock buybacks and dividends, IBM also has high-switching costs built into their products and services. Installing an IBM mainframe and enterprise system is very expensive, and once the customized systems are installed, customers typically remain with IBM for a long time. In addition, IBM continuously invests in R&D (large patent portfolio) in order to shift toward higher margin software offerings. Finally, IBM's outsourcing contracts provide recurring revenue, and their contracts typically are for 6-7 years.
3) Network Effect: The network effect occurs when the value of a particular product increases for both new and existing users, as more and more people use the product. In addition, if other firms design complimentary products, it enhances the original product's value even more. Network effect is probably most apparent in the tech industry. Social media sites such as Facebook (FB) benefit from having more and more users on their platform. Unfortunately, Facebook's valuation is a bit too lofty for me at current levels (if it trades down to around $20ish again, then I would be interested). Another company that benefits from network effect is Apple (AAPL). App developers are attracted to continue to develop apps for Apple's ecosystem, and consumers value the diversity of apps available on their Apple iPhone and iPad. Apple has been beaten down recently due to competition and margin concerns (click here for my recent article on Apple and lessons I learned from it), but if you are a new investor into Apple, this could be a good entry point.
4) Brand Equity/Intangible Assets: Intangible assets can include patents (like IBM mentioned above), but it can also include brand name or brand equity. A strong brand name reflects the company's reputation, and it takes time, execution and consistency to be able to earn that reputation from your consumers. The quality and trust reflected by a strong brand that has earned that reputation, can significantly influence consumer decision at the moment of purchase (people lean towards things that they are familiar with). While there are numerous companies that have a strong global brand, I personally like Coca Cola (KO) and McDonald's (MCD), given that they also tend to be recession resilient as well (people still need to drink and eat lost-priced items when times are tough).
5) Distribution Network: Finally, a strong global distribution network can provide a significant advantage over competitors and can also be considered an economic moat. For example, a company like Proctor and Gamble (PG) has built a first-class, global distribution network (distributors, supermarkets, convenience stores, warehouse clubs, etc.) that would take decades for new entrants to attempt to create on their own. This distribution network also allows Proctor and Gamble to quickly launch and push new products into the market through their existing network. Johnson and Johnson (JNJ) has a consumer segment that sells health and beauty products, baby care, oral care, over-the-counter drugs, etc. that also benefits tremendously from their global distribution network.
Conclusion: Understanding the qualitative thesis for owning a stock is just as important as understanding the quantitative fundamentals of a company. Often, the qualitative aspects of a company (strong brand name) drive and explain the quantitative aspects of a company (international sales and high net margins). This article attempts to highlight some qualitative benefits that may help a company sustain its competitive advantage (its economic moat) in the long run. As always, investors need to follow that up with their own regular homework and diligence (to make sure the company's financial performance and competitive edge is not deteriorating over time). Good luck and happy Chinese new year.