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One of the first rules learned by investors who try to emulate some of the time-tested strategies of Berkshire Hathaway (BRK.A) CEO and Chairman Warren Buffett is to buy companies with strong moats, or durable competitive advantages. Of course, this is a somewhat subjective exercise, and many investors who try to explain the given moats of their favorite companies might find themselves using the same rationale as Supreme Court Justice Potter Stewart, who in 1964, described what constitutes pornography as, “I know it when I see it.”

Naturally, the quest to identify companies with very strong moats is a worthwhile endeavor because although no investment may ever truly qualify for that elusive “Buy and Hold Forever” category, we can still try to find companies with competitive advantages that are so strong and durable that they will likely exist until long after we are gone. I was recently reading “Investing in Equity Markets” by Summer, and he gives a fantastic quote by Warren Buffett on page 80 that comes as close as anything I have ever seen to approximately quantifying what investors ought to consider a strong moat:

The test of a franchise is what a smart guy with a lot of money could do to it if he tried. If you gave me a billion dollars, and you gave me first draft pick of fifty business managers throughout the United States, I could absolutely cream both the business world and the journalistic world. If you said, ‘Go take The Wall Street Journal apart,’ I would hand you back the billion dollars. Reluctantly, but I would hand it back to you. Now, incidentally, if you gave me a similar amount of money and you told me to make a dent in the profitability of Omaha National Bank or the leading department store in Omaha, I could give them a hard time. I might not do much for you in the process, but I could cause them a lot of trouble. The real test of a business is how much damage a competitor can do, even if he is stupid about returns.There are some businesses that have very large moats around them and they have crocodiles and sharks and piranhas swimming around in them. Those are the kind of businesses you want. You want some business that, going back to my day, Johnny Wiessmuller in a suit of armor could not make it across the moat. (Summer, 80)

Part of this quote may explain why I have such a favorable regard for consumer staple companies with strong brand names—not only do they sell products that people have to purchase repeatedly that earn decent margins, but the strong brand name is often a strong deterrent that crates a barrier to entry for other companies.

How many executives out there are thinking, “Let’s come up with a new noodle and cheese combination for macaroni and cheese so that we can displace Kraft (KFT) as the dominant mac-n-cheese producer in North America?” Probably hardly any. Kraft has tremendous economies of scale, sells macaroni on the shelves of almost every grocery store for only about a $1, and quite a lot of people are going to pay the extra $0.25-$0.33 to go for the name brand they recognize over an unknown or seemingly generic competitor.

The same thing is true for Proctor & Gamble (PG). Last year, I tried to convince myself that I was being just another “mindless consumer” who automatically buys the name brand product—and so I thought I’d give the generic yellow razors a try instead of Gillette when I stopped by Wal-Mart (WMT). It was an awful experience—I swear, I can still feel the blood. I went back to Gillette in a hurry, and there’s a pretty decent chance I’ll stick with it for the rest of my life. From the perspective of a Proctor & Gamble investor, that is exactly the kind of loyalty you want to see.

When a parent has a sick child with a headache or a toothache or whatever it may be, do you think a lot of them are going to automatically pick the cheapest option available, or do you think they’re going to stick with the name they trust and pay the extra $0.50 for Johnson & Johnson’s (JNJ) Tylenol? My best guess is the latter.

Warren Buffett regards Coca-Cola (NYSE:KO) as the ultimate moat stock because it would be almost impossible for a start-up to displace Coke, Diet Coke, Sprite, etc. as the dominant carbonated beverage provider in most markets. As an investor, it’s easy to apply the Buffett test and determine that it’s very unlikely that Heinz (HNZ) will be replaced as the dominated ketchup provider or Clorox (CLX) and Colgate-Palmolive (CL) will be pushed aside by an upstart household cleaner product company. While anything is possible, the odds of these companies doing well for the long haul are in your favor as the investor. A couple of my recent articles have discussed Benjamin Graham’s advice to always seek a margin of safety—the greatest amount of leeway for things to go wrong and investments to still turn out well—and strong brand names with competitive advantages seem to come with this advantage almost built-in. Strong brand names can even excuse the typical follies of management—bad pricing, bad acquisitions, bad capital deployment strategies—but it’s going to take quite a few mistakes from management for Pepsi (PEP) to stop making a profit from Pepsi, Diet Pepsi, Gatorade, Lay’s Potato Chips, Fritos, etc. Buffett has done quite well buying companies with strong moats and holding them for the long haul, and you too will most likely do quite well over your investing career if you limit yourself to buying the best-in-breed companies that are able to use their competitive moats as an engine to generate ever-growing profits and dividends.

Source: How To Find Stocks With Strong Moats