By JACK HOUGH
When investors talk about a "wide moat" company, they mean one able to defend its profits from marauding competitors.
Such companies are worth watching. One gauge, the Morningstar Wide Moat Focus index, has returned 6.3% a year since it began in 2007, versus 0.6% for the Standard & Poor's 500-stock index.
Moat-based investing isn't new. Warren Buffett has used the term 20 times since 1986 to describe his investment process in annual letters to Berkshire Hathaway (BRKB)
Moats can offer both solid returns and safety, says Chuck Joyce, who along with Kimball Mayer oversees $20 billion for Boston asset manager GMO. While economic theory says companies cede competitive advantages over time, a recent paper by Messrs. Joyce and Mayer shows that since 1966, the highest-return companies in a given year tended to retain that status five years later.
The problem for investors: Moats aren't defined by accounting regulators or measured in company reports. Here are some ways to spot them.
Begin with some clues from Mr. Buffett's 2007 letter, a primer on moats with its eight mentions of the term. One moat example for companies is being the lowest-cost player in an industry, as in the case of Berkshire holding Geico insurance. Another is a strong brand, like Coca-Cola (KO)
The purpose of a moat isn't to ensure rapid growth, but rather to protect "returns on invested capital," Mr. Buffett wrote. Formulas for calculating ROIC vary slightly from analyst to analyst, but the basic idea is to divide a company's operating profit by the amount of capital it uses to generate that profit.
Moats and high ROICs aren't the same thing, but one often accompanies the other. Morningstar (MORN),
Beyond ROIC, Morningstar's "moat committee," which analyzes 1,800 stocks, considers less-measurable sources of competitive advantage, says Paul Larson, the firm's chief stock strategist. For example, companies like eBay (EBAY)
Messrs. Joyce and Mayer select moat stocks by studying the amount of cash companies retain each year, and whether that cash propels future profits higher. Their GMO Quality III
Alas, for most investors, the fund has a barrier to entry of its own: a $10 million investment minimum. But its stock holdings are publicly reported, and they don't change often. Top positions include Microsoft (MSFT),
Morningstar recently teamed up with asset manager Van Eck Global to turn its moat index into an exchange-traded fund, Market Vectors Morningstar Wide Moat Research (MOAT)
Be warned: No consideration is given to sector weightings, and that can produce some striking shifts. In 2010, "consumer discretionary" companies, a category that includes stores and movie studios, made up more than one-third of the portfolio. During the first quarter of this year, it made up zero.
Investors also can hire the moat-spotting and caretaking services of Mr. Buffett himself, with a purchase of Berkshire Hathaway.
By some measures the stock is a bargain. Berkshire since 1985 has fetched an average price 60% greater than the accounting value of its investment holdings -- the so-called Buffett premium. Now it stands at just 15% -- suggesting Mr. Buffett's expertise is on sale. Moats matter, but so do reasonable prices.—Jack Hough is a columnist at SmartMoney.com. Email: firstname.lastname@example.org