How moats protect your investments

If you have ever had the chance to travel around Europe, you may have included on your itinerary a visit to a medieval castle. With the days of knights, chain mail and lances now consigned to history, it is an army of tourists that now patrol the ramparts and drawbridges.

One of the more impressive features on many of these castles is the moat that surrounds them. These are deep and wide ditches, usually filled with water, whose primary function was to protect castles from enemy attack.

The moat acted as a first line of defence to prevent invaders from using battering rams, scaling ladders and siege towers up against the walls of the castle. As the medieval days were frequently violent, common homes were vulnerable to pillaging, so castles with their deep and wide moats offered safety and protection.

In investing we want a similar level of safety and protection and that's why we look for companies that have wide economic moats.

An economic moat is a competitive advantage that a business may have, that enables it to maintain and increase profits well into the future, whilst keeping its competition at bay. If a company has a weak moat or no moat at all, it becomes very hard to value, as future profits become hard to predict.

So what sort of thing can provide a company with an economic moat?

A valuable brand can go a long way to keeping the competition at bay. Brands can create positive psychological associations in consumers' minds. In its 2015 brand survey, Interbrand ranked Apple as the most valuable brand in the world, with a value of $170bn, followed by Google ($120bn), Coca-Cola ($78bn), Microsoft ($68bn) and IBM ($65bn). All have valuable brands that consistently bring people back to their products. Gillette is another quality brand (ranked 22^nd with a value of $22bn), which is almost synonymous with high-quality shaving products, with more than 70% of the retail razor blade market. The strength of Gillette's brand is such that many will use its products their whole life and be willing to pay a little extra to do so.

Ownership or control of unique, monopoly assets can provide a company with an almost unassailable moat (although these often come at the cost of regulation). Sydney Airport (ASX: SYD) and Transurban (ASX: TCL), for example, have long leases on exclusive infrastructure assets. Ramsay Health Care's (ASX: RHC) hospitals also enjoy monopolistic characteristics in an industry where demand is consistently outstripping supply.

Patents and Intellectual property also provide strong moats. A patent gives a company the exclusive right to sell its product or invention for a given period of time. CSL (ASX: CSL) and Cochlear (ASX: COH) both hold patents and trademarks that allow them to exclusively generate revenue from their products.

Where a company can produce its product more cheaply than the competition, it will also enjoy an almost impregnable position. Cost advantages typically appear due to economies of scale, but there are other potential sources, such as favourable access to raw materials or distribution.

Switching costs may also provide an economic moat, where the cost of switching from a company's product or service is greater than any potential benefit, so people stay with the incumbent. Network effects can also provide a strong moat, where a service becomes more valuable the more people that use it (think of a telephone network or social media services such as Facebook).

Warren Buffett once said: ‘In business, I look for economic castles protected by unbreachable moats'. The size of these moats though, can change and every year he asks his managers to continue to widen their moats.

‘Every day, in countless ways, the competitive position of each of our businesses grows either weaker or stronger,' explains Buffett. ‘If we are delighting customers, eliminating unnecessary costs and improving our products and services, we gain strength. But if we treat customers with indifference or tolerate bloat, our businesses will wither'.

Whenever a company is successful, others will want to compete, so the wider and deeper a company's moat, the better chance it has of surviving.