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When looking at dividends and the sustainability of those dividends, I always look to the characteristics of the underlying business that I am invested in to determine the durability of the dividends and the likely level of dividend increases. The existence of moats play a big role in that process.

What are moats?

I believe it may have been Warren Buffett that first came up with the concept of moats to apply to investing. It's a term that you hear in business strategy discussions often. At its most basic, the idea of a moat refers to the advantages that a business possesses to help keep out invaders from overrunning their "fortress" so to speak.

In other words, it's the set of tools and competitive advantages that a business possesses to repel competitors from completely commoditizing their business, damaging revenue growth, margins and profitability.

Moats are significant for dividend growth. A company with no moat or a subpar moat will soon find their business overrun with competitors, if they are experiencing significant revenue growth. Success generally attracts competition.

Prices will get pushed down and the business may experience revenue declines and profit issues. If its lucky and the market the business is in is growing strongly, it may continue to retain its share of the growth. If its unlucky the consequences may be far worse.

Retaining a moat over a long period of time is pretty tough, but as a dividend growth investor, I think you need to be invested in companies that will have a moat for years. Ultimately, the way you drive lasting dividend increases is through increases in top line revenue, which should be managed into sustained increases in profit and cash flow.

There's no other way to generate strongly increasing dividends over the long term. Sure you can squeeze out expenses and you can boost the amount of retained profits that are paid out of the business.

Unfortunately, there are only so many expenses you can squeeze before you damage the company brand and unique value proposition. Paying out too much in retained profits as dividends brings the risk of underinvestment in the business. You don't innovate. Your value proposition becomes stale. Somebody else outflanks you.

Companies that have proven their ability to retain their moats over many years are strong candidates to consider for dividends. They've proven they have a value proposition that they can defend and which is enduring. That's not to say that moats last forever.

There are a number of different types of moats

Intellectual Property

The best moat in my opinion is one that is protected by law. You have some unique formula, some secret sauce that you own and then makes billions from.

Coca Cola (NYSE:KO) has a unique intellectual property, protected via layers of Non Disclosure Agreements and clauses around its formulation for Coke. Apparently it's so well guarded that its tucked away in a secret safe somewhere with heavy security. It better be. It accounts for a significant portion of the value of a $180B business.

Pharmaceutical companies were at one time the most effective users of patents. Of course, they generally only have patent exclusivity for 7 years after which point generics are able to come in and replicate block buster drugs. Hence the big pharma moat is not as wide as Coca Cola in my view, as they have a more limited form of IP protection.

Qualcomm (NASDAQ:QCOM) is probably one of the least well known examples of strong IP commercialization. But they've made a mint from the patents they hold for CDMA radio technology, which is the basis of the architecture operated by folks like Verizon (NYSE:VZ) Wireless. It's a bit hard to negotiate pricing with someone when they are the only game in town.

Regulation

Regulated moats are also protected by law. Certain companies have the benefit of regulation which confers a barrier to entry to a competitor looking to enter a market.

Banks are a good example. Not anyone can just up and decide they are going to become a bank. You need a certain level of capitalization, you need to be regulated by the FDIC and you need to show ongoing compliance with a variety of regulations. It isn't an easy manner for the next JP Morgan (NYSE:JPM) to be spun up

Provision of utility type services also requires being approved and regulated by certain bodies and being compliant with a variety of standards.

Telecommunications providers like Verizon for instance need to be regulated by the FCC while operators of power and gas plants also have certain conditions that they need to comply with in order to maintain their permits to operate these plants.

While regulated utilities tend to be cash generating machines, they can have fairly low rates of revenue growth. Providers of gas and electricity services negotiate with state agencies for rate increases that they in turn are allowed to charge customers.

Of course while these can occasionally be generous, being dependent on state agencies for returns typically translates into limited scope for revenue increases, which in turn can translate to pretty limited dividend growth.

Switching costs

Switching costs refer to the ease of customers being able to easily move a service from one provider to another.

From a consumer point of view, you can see some limited switching costs in moving from one bank to another. The hassle of going down to a branch to close an account or switch your mortgage can make consumer banking a fairly sticky service. People are generally loathed to go through the hassle of making such a switch.

Similarly, Apple (NASDAQ:AAPL) has done a pretty good job of building in switching costs into the Apple ecosystem. By have proprietary formats for music, video etc, it becomes difficult for someone to up and leave to another platform without having to go through a massive effort of converting their content library into another format.

You tend to find much stronger examples of switching costs in the enterprise. It's not easy for an Enterprise customer to migrate over from an Oracle (NYSE:ORCL) ERP system to SAP without a lot of effort and integration planning.

Similarly, payroll providers like ADP (NASDAQ:ADP) and Paychex (NASDAQ:PAYX) have a very strong lock on companies with their payroll processing systems. The amount of effort to move over to a different payroll system is non trivial.

Marketing & Distribution

A number of companies have perfected a tight package of distribution and operational efficiency to complement a core product or IP. It's hard to have a sustained competitive advantage with just marketing and distribution alone without a killer product, but together with a great product, having a competency here can give you an enduring moat.

Coca Cola, Pepsi (NYSE:PEP) and even McDonald's (NYSE:MCD) have perfected a great product with distribution and operational efficiencies. They are able to move cans of coke or set up the production of french fries in many places around the globe, delivered in a standardized manner with consistent quality.

That you can have a set of McDonald's fries taste the same in any restaurant around the globe considerably enhances McDonald's brand capital and the likelihood of repeat visits from consumers.

Fastenal (NASDAQ:FAST), which manufactures and distributes fasteners used in manufacturing can claim a moat based on its ability to distribute any fastener to any location within the fastest amount of time.

Location

In certain industries, location can lend itself to the existence of an economic moat. Companies such as Burlington Northern and CSX (NYSE:CSX) have economic moats by virtue of where the railroad assets are located.

Having rail tracks in high trafficked corridors, or those with strong economic activity creates a moat because the existence of that infrastructure makes it less likely that another competitor can come along and replicate that access given the need to negotiate new access permissions across territories and set up similar infrastructure.

Finally location can be a huge strategic advantages for mineral and aggregates producers. Having a quarry located close to a port can make a huge difference in terms of the viability of development.

Of course, being located close to a customer site can lead to a significant competitive advantage and economic moat, and other competitors may not be able to claim an equivalent advantage. Vulcan Materials (NYSE:VMC) economic moat stems from the fact that it is located so close to many of its customers and it is not economically viable to transport aggregates more than 50 miles.

The widest moats

The widest moats come from a combination of multiple individual moats. Consider the case of McDonald's, which has multiple economic moats in my view. McDonald's have considerable IP around the production of a variety of food products at low cost. Further, they are able to distribute and standardize the production of those products across a number of store formats and countries.

Finally McDonald's stores have the advantage of being located in high trafficked areas which are heavily frequented. All of these things put together provide McDonald's with a wide economic moat, and provide McDonald's with considerable brand equity, which it can use to roll out new products and new format stores (i.e. McCafe).

While the payment of sustained dividend increases can be inherently uncertain in a dynamic competitive environment, the existence of an economic moat can help add a degree of confidence that a company can continue to maintain and increase its dividend and keep competitors at bay.

Source: Why Your Dividend Investment Needs A Moat