Warren Buffett has a secret. Despite him repeating this wealth building secret over and over again during his speaking engagements and investor letters, most investors disregard or flat out ignore this true stealthy secret to his stock-picking savvy.
Warren Buffett has a secret. Despite him repeating this wealth building secret over and over again during his speaking engagements and investor letters, most investors disregard or flat out ignore this true stealthy secret to his stock picking savvy.
I have studied Warren Buffett for many years. I am convinced that this one stock picking strategy is the true secret to his long-term success in the stock market.
You are probably thinking this secret has something to do with dividends or earnings. While these things are important fundamental metrics for every stock picker, what I am referencing has nothing to do with any traditional stock analysis techniques.
In fact, this secret cannot be quantified and is truly untraditional.
Buffett calls this secret, an economic moat.
He believes in this idea so strongly that he has stated:
“A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns.
“Therefore a formidable barrier such as a company’s being the low-cost producer or possessing a powerful world-wide brand is essential for sustained success.”
– Warren Buffett, 2007 Berkshire Hathaway Shareholder Letter
First, let’s take a closer look at Warren Buffet himself.
Buffett is known as the Oracle of Omaha due to his incredible investing success. He is considered the greatest stock picker of all time.
This ability has earned him a place as one of the wealthiest men alive today. Despite his vast wealth, Warren continues display a public persona of humility and common folk wisdom.
This attitude has provided him the respect of working people as well as the ultra-rich; a very rare combination in this day and age. He does not believe in personal or family dynasties and has pledged to give away 99% of his wealth in his will.
Not so long ago he joined forces with Bill Gates in a philanthropic trust arrangement to use his wealth for the betterment of mankind.
How did Warren Buffett obtain the skills and knowledge to create his empire ?
Many investors erroneously believe that he was simply lucky, others are certain he was born with a gift for investing, still others think he must have some kind of supernatural stock picking gift unavailable to the everyday investor. Well, nothing can be further from the truth.
Buffett learned his investing skills from Benjamin Graham, David Dodd and Phil Fisher.
Graham and Dodd are considered the fathers of value investing. They were professors at Columbia University, where Buffett received his MS in economics.
Graham and Dodd are also the authors of “Security Analysis”, the seminal book on investing. Buffett describes himself as 85% Graham and 15% Fisher is his stock picking philosophy.
The three main ideas from Graham Buffett attributes to his success are to look at stocks as individual businesses, use the market’s fluctuations to your advantage and finally, be certain that there is a margin of safety built into all your investments. This stock picking method is widely known as value investing.
Value investing follows the idea of buying stocks that are underpriced per fundamental analysis. In other words, stocks are bought at a discount to their intrinsic proper market price. This discount is what Graham considered the margin of safety.
Graham’s margin of safety is what he stressed over and over again to Buffet and in his books. He taught that investors should be more concerned about the downside of the stock than the upside. In other words, watch the losses and the wins will take care of themselves. One way to assure a significant margin of safety is to buy stocks with strong balance sheets and industry dominance.
However, above all these things, Buffett speaks of the economic moat as being the most critical factor.
Investopedia defines economic moats as follows:
The term economic moat, coined and popularized by Warren Buffett, refers to a business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms. Remember that a competitive advantage is essentially any factor that allows a company to provide a good or service that is similar to those offered by its competitors and, at the same time, outperform those competitors in profits. A good example of a competitive advantage would be a low-cost advantage, such as cheap access to raw materials. Very successful investors such as Buffett have been very adept at finding companies with solid economic moats but relatively low share prices.
Now that you understand the idea of the economic moat, how do you go about finding companies that fit the criteria?
Equities research firm Morningstar has identified 5 critical factors that every stock with a wide economic moat possesses.
- Network Effect. The network effect occurs when the value of a company’s service increases for both new and existing users as more people use the service. For example, millions of buyers and sellers on eBay EBAY give the company an advantage over other online marketplaces. The more sellers there are on eBay, the more likely buyers are to find what they’re looking for at a decent price. The more buyers there are, the easier it is to sell things.
- Intangible Assets. Patents, brands, regulatory licenses, and other intangible assets can prevent competitors from duplicating a company’s products, or allow the company to charge a significant price premium. For example, patents protect the excess returns of pharmaceutical manufacturers such as Novartis NVS. When patents expire, generic competition can quickly push the prices of drugs down 80% or more.
- Cost Advantage. Firms with a structural cost advantage can either undercut competitors on price while earning similar margins, or they can charge market-level prices while earning relatively high margins. For example, Express Scripts ESRX controls such a large percentage of U.S. pharmaceutical spending that it can negotiate favorable terms with suppliers like drug manufacturers and retail pharmacies.
- Switching Costs. When it would be too expensive or troublesome to stop using a company’s products, the company often has pricing power. Architects, engineers, and designers spend entire careers mastering Autodesk’s ADSK software packages, creating very high switching costs.
- Efficient Scale. When a niche market is effectively served by one or a small handful of companies, efficient scale may be present. For example, midstream energy companies such as Enterprise Products Partners EPD enjoy a natural geographic monopoly. It would be too expensive to build a second set of pipes to serve the same routes; if a competitor tried this, it would cause returns for all participants to fall well below the cost of capital.
There is one final metric to Buffett’s Moat tactic.
The final consideration to utilize the moat tactic just like Warren Buffett is share price.
The share price of the stock needs to be trading at a discount to the actual value of the company before Buffett considers investing.
If the share price is above the actual value of the company, Buffett will avoid the stock no matter how wide the economic moat.
However, if the share price is trading at a discount and the company boasts a wide economic moat, Buffett will buy aggressively.