In the Middle Ages moats were deep water-filled trenches that encircled castles to protect kings. The wider, the better.In 2007 moats are the competitive advantages that protect dominant companies and their shareholders. The wider, the better.
The goal in trying to pick companies with wide moats is to give investors the security of knowing that a firm isn't likely to see its products or services overtaken by rivals.
Although many of these companies are king-size, some smaller niche players qualify too. Of course, the trick is not to pay too dearly for a stock to obtain this higher level of confidence.
"Very few moats are impenetrable, but some are certainly more durable than others," said Nathan Slaughter, editor of StreetAuthority.com's Half-Priced Stocks newsletter. "To evaluate how long a competitive advantage might remain before it begins to crumble, identify the factors that provided the moat in the first place."
For example, the bulk of cash generated by the vacation cruise industry flows directly to Carnival Corp. (CCL) and Royal Caribbean Cruises Ltd. (RCL), Slaughter said. Because it costs more than $500 million to build a luxurious new cruise liner these days, it would be daunting for any competitor to enter that game.
Similarly, in the refuse business, Waste Management Inc. (WMI) enjoys a wide moat because it owns more government permits for solid waste landfills than its three closest rivals combined, he said.
Investors must remain on guard for competitive change. Consider that the operating income earned by casino operator Harrah's Entertainment Inc. (HET) at its Atlantic City resorts plunged nearly 38 percent in the second quarter due to the introduction of competing slot machines in new jurisdictions in nearby New York and Pennsylvania, Slaughter said.
"A company's moat is important, but consider it just one investment metric, one arrow in the quiver," said Jeffrey Saut, chief investment strategist for Raymond James & Associates in St. Petersburg, Fla. "It is not the golden fleece."
Many motorists are hooked on global positioning systems for accurate directions, which has turned Trimble Navigation Ltd. (TRMB) and Garmin Ltd. (GRMN) into investment home runs. But GPS is proliferating and generic competitors are surfacing. With pricing coming down and profit margins being compressed, Saut chose a different tactic.
"To make any GPS work, you must have the proper data, and only two companies in the world have it, which means a wide moat," said Saut, who owns shares in both of those firms: Navteq Corp., and Tele Atlas N.V., which is being acquired by TomTom N.V. for nearly $2.8 billion.
In health care the key companies producing breast implants are Mentor Corp. (MNT) and Allergan Inc.(AGN), and others hoping to enter the field would need myriad government approvals, he said. Another health-care wide-moat company with great potential is Intuitive Surgical Inc. (ISRG), which produces robotic tools for surgery.
Choicepoint Inc. (CPS) provides the data necessary for insurance firms to screen customers and the government to do background checks, he said. He is neutral on that stock because its price has advanced.
"You find fewer moats in technology because it changes so frequently, or in consumer products because the cost to switch products is low," said Pat Dorsey, director of stock analysis for Morningstar Inc. in Chicago.
Yet even in technology Oracle Corp. (ORCL) benefits from the difficulty and cost required to switch out of its database software, while Microsoft Corp. (MSFT) enjoys the powerful network effect of having so many offices use its products, Dorsey said. In consumer products a small group of companies, including Target Corp. (TGT) and the Home Depot Inc., (HD) are powerful enough in their segments to benefit from huge economies of scale.
Dorsey believes investors must watch for one of four types of competitive advantage to identify a wide-moat company:
-- An intangible asset, such as a strong brand, patent or mandatory approvals, which creates a "mini-monopoly." Nobody else can sell Coca-Cola because it is Coca-Cola Co. (KO); no one can sell Lipitor but Pfizer Inc. (PFE) until it goes off patent; and no one can open a casino in Macau without a license from the Chinese government.
-- An expensive switching cost that locks your customer in and makes it difficult to move to a competing product. Changing databases, for example, is no snap.
--- Having the network effect. MasterCard Inc. (MA) cards are accepted virtually everywhere, an enormous hurdle for new competitors, just as eBay Inc. (EBAY) benefits from its vast number of users.
Another prime wide-moat company is Adobe Systems Inc. (ADBE), which produces the Photoshop, Acrobat and Flash products used in designing and graphics, Dorsey said.
Other wide-moat firms: International Speedway Corp. (ISCA) owns a dozen motor sports race tracks and therefore plays a significant role in deciding where people will race; McCormick & Co. (MKC) is a relatively small company that dominates the spice industry; and William Wrigley Jr. Co. (WWY) leads the chewing gum industry because of loyal customers.
Moats, however, can shrink quickly, so investors must be watchful.
Andrew Leckey is a Tribune Media Services columnist.