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Warren Buffett Explains His Moat Principle

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·4 min read
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Something Warren Buffett (Trades, Portfolio) is always on the lookout for when evaluating potential investments is whether or not they have a moat around the business.

The Oracle of Omaha has been referring to his moat analogy for decades. In order to be successful, a company must have a definite moat, aka a competitive advantage that allows it to maintain pricing power and better than average profit margins.

These factors usually translate into more significant returns for investors over the long-term as companies can return more capital to their owners. Businesses with durable competitive advantages do not have to invest much back into the enterprise to maintain this competitive advantage, unlike commodity businesses.

Buffett on the moat

Buffett explained his moat principal at the 1995 Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) annual meeting of shareholders.

"What we're trying to do," he said, answering a question from the audience, "is we're trying to find a business with a wide and long-lasting moat around it, surround -- protecting a terrific economic castle with an honest lord in charge of the castle."

He then went on to explain some key traits a company with a moat must have:

"What we're trying to find is a business that, for one reason or another -- it can be because it's the low-cost producer in some area, it can be because it has a natural franchise because of surface capabilities, it could be because of its position in the consumers' mind, it can be because of a technological advantage, or any kind of reason at all, that it has this moat around it."

When he's found a business with a large moat around it, the next stage in Buffett's process is to try and figure out what's keeping the moat intact:

"But we are trying to figure out what is keeping -- why is that castle still standing? And what's going to keep it standing or cause it not to be standing five, 10, 20 years from now. What are the key factors? And how permanent are they? How much do they depend on the genius of the lord in the castle?"

Once Buffett and his right-hand man, Charlie Munger (Trades, Portfolio), have established the above factors, the next stage is to try and establish how capable the company's manager is:

"And then if we feel good about the moat, then we try to figure out whether, you know, the lord is going to try to take it all for himself, whether he's likely to do something stupid with the proceeds, et cetera."

The three-step process

That's the three-step process Buffett said he used to evaluate businesses back in 1995. Based on his comments over the past two and a half decades, it doesn't look as if his process has changed much since then. It continues to revolve around finding businesses that have a strong moat or competitive advantage.

When the Oracle of Omaha has found these businesses, the next step is to establish how strong the moat is and whether or not the company will still be standing one or two decades down the line. The final stage is to assess the quality of management.

If all three of the above provide a positive result, then the CEO of Berkshire Hathaway will look to invest in a business at a discount valuation.

It seems he uses the same process to evaluate both public equity investments and private buyouts. He wants to be sure that the companies he invests in will still be around in several decades' time and throwing off cash for the shareholders of Berkshire.

This strategy isn't particularly easy, and it requires a lot of work and effort. Nonetheless, the results over the long term have been nothing short of outstanding.

Disclosure: The author owns shares in Berkshire Hathaway.

Read more here:

  • Warren Bufett: No Need to Be Jealous of Lottery Winners

  • What the Tesla Share Price Can Teach Us About Investing

  • The Sequoia Fund's Founders on Patience

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This article first appeared on GuruFocus.