If I asked you to name one of America’s greatest companies, I would undoubtedly receive a wide range of responses.

Many might name Apple (NSDQ: AAPL) because of the way it has transformed our daily lives with its revolutionary mobile devices. Some would choose Amazon (NSDQ: AMZN), whose massive e-commerce platform generates a staggering $500-plus billion in annual sales. Still others would point to Walt Disney (NYSE: DIS), an iconic business whose beloved movies, characters, and theme parks are enjoyed by millions.

There is no right or wrong answer, merely opinion. The point is to provoke a discussion of which attributes make a company “great.” Is it a dominant market share? Sky-high profit margins? A cash-rich balance sheet?

I would argue none of the above.

Imagine an undefeated 12-0 football team. Pundits might swoon over its offensive yardage, third-down conversion rates, red-zone efficiency, or league-leading touchdown totals. But none of those stats makes the team great; they’re simply the byproducts of a great team.

The real credit goes to something opponents don’t have, such as an impenetrable offensive line, a rifle-armed quarterback, or a genius coordinator calling all the right plays. Take those secret weapons away and suddenly you’re looking at an average 7-5 team.

In much the same way, you can’t judge a company’s potential by focusing blindly on sales growth and operating margins. They are just statistical byproducts — numbers pulled from an income statement.

Trust me, numbers can and do change overnight.

Just a few years ago, Bed, Bath & Beyond was raking in $10 billion in annual sales and producing hundreds of millions in profits. Now it’s bankrupt. History is littered with companies that couldn’t adapt and fell by the wayside.

The most dominant companies almost always possess something that rivals lack, a competitive advantage that tilts the playing field in their favor. These advantages are what separate the good from the truly elite.

I’m talking about an economic moat.

Why ‘Economic Castles’ Need Moats

Long-time readers know that I place a great deal of emphasis on competitive advantages and economic moats. In fact, barely a single issue goes by that I don’t cite at least one or two examples (particularly when evaluating new portfolio candidates). But while these terms are frequently mentioned, it has been a long time since we really dug into the concept.

That’s what today’s issue is all about.

Fortunately, it’s a fairly simple analogy. In medieval days, wide moats encircling a castle would help protect the inhabitants from marauding invaders. Today, the same notion applies to figurative defensive fortifications that help businesses fend off the encroachment of competitors.

The stronger the fortification, the better protected the company — and the higher its long-term shareholder returns.

Otherwise, there’s nothing stopping a future rival from setting up shop next door and charging a dollar less, siphoning away customers.

There is perhaps no bigger proponent of this philosophy than Warren Buffett, whose comments on the subject could fill a book. Longtime partner Charlie Munger was a fan as well, declaring moats to be one of four load-bearing pillars of a lasting stock (the others are management integrity, an understandable business model, and a reasonable share price.)

Seeking “economic castles protected by unbreachable moats” has been the very cornerstone of Berkshire Hathaway since Buffett took control in 1965. And it has paid off handsomely — Berkshire stock has since outperformed the S&P more than 150 times over.

Buffett is certainly not alone in using this strategy. Countless money managers, venture capitalists, and other financial luminaries subscribe to the importance of moats.

“The definition of a moat is the ability to charge more”
— Marc Andreessen

“You can’t truly know the moat [exists] until that moat is attacked and the attack is repelled… Capitalism [is] like nature; it’s just a brutal place.”
— Jeff Mueller

“Nothing breeds copycat competition better than success… To maintain success, all companies must invest to extend their moat.”
— Marathon Asset Management

“We are big fans of companies focused on widening their moat… rather than trying to top analyst estimates for the next quarter.”
— Jake Rosser

“What’s most important to us is that each company has a massive competitive moat that allows for [the] compounding of growth to occur without a lot of risks.”
— Dan Davidowitz

“We devote probably 90% of our intellectual horsepower to understanding whether the competitive moat around the business is widening or narrowing.”
— Christopher Begg

It stands to reason that any highly profitable business making boatloads of cash is bound to attract imitators. That’s Economics 101. It’s particularly true of innovators with novel new ideas and disruptive products and services. Everyone wants in on the next big thing. The trendsetter may prosper for a while, but success inevitably invites competition.

To attract — and retain — customers, the incumbent leader usually has to accept lower prices or find a way to build a better mousetrap. It won’t happen overnight. But these competitive pressures gradually erode the excess profits, eventually driving returns in the industry down toward its cost of production.

It’s a tale that has played out over and over. With the constant advance of technology, we’ve even seen entire industries upended — and occasionally pushed to the edge of obsolescence. You don’t see many retail music stores these days. Cable TV companies are fighting this battle right now against the rise of video streaming.

Picture hordes of zombie competitors crashing against the gates and you can understand the importance of keeping them out. Most businesses eventually get overrun. But those with wide — and durable — moats can repulse attacks and produce superior returns for years… or even decades.

Stay tuned. In tomorrow’s post, we’ll explore the six types of moats companies can build (or dig?) to successfully fortify their business.

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