It does not take Warren Buffett to advise investors to invest in companies that have a competitive advantage; any financial analyst will take the same stance. What Warren Buffett really means is that these companies have a wide moat, similar to the moats of yore that represent the best defense element for castles. Thus, wide moat companies are simply the ones that manage to build up a strong defense against predatory competitors. Since 1986, Warren Buffett has used the term no less than 20 times to describe his investing philosophy in annual letters to Berkshire Hathaway.
So how can you mimic this strategy and follow Warren Buffett into wide moat stocks?
Analyzing companies that can fall into the category of wide moat is not just a matter of applying conventional quantitative methods, but a qualitative approach also needs to be taken, as these companies are not defined as wide moat by government regulators, or even the companies themselves.
The purpose of the moat is not to ensure rapid growth, but rather to reinforce Return On Invested Capital (ROIC), calculated as operating profit divided by capital deployed to secure that profit, and also apparently a very important measure of performance to Warren Buffett. Although moats and ROICs are not necessarily the same thing, one often follows the other.
The prominent player in the wide moat category is Morningstar, which has produced wide moat ratings since 2007. Their Wide Moat Focus index has purportedly returned 6.3% annually since 2007, compared to 0.6% for the S&P 500. Furthermore, over the past three years, wide moat companies have boasted of a median ROIC of 13.3%, compared to 7.6% for narrow moat companies, and Morningstar’s GMO Quality III fund has been among the top 3% of large company mutual funds in the five year performance category.
However, a new ETF has recently been launched under the name of Market Vectors Morningstar Wide Moat Research ETF (ARCA:Moat), that seeks to track the the Wide Moat Focus index. As of May 2012, assets under management has only reached $11 Million, and the ETF boasts of a very affordable 0.49% expense ratio. Presently only holding 20 stocks, it is still well diversified considering that the largest holding only amounts to 6.2% of assets, with the smallest at 4.5%.
Let us follow Warren Buffett into wide moat stocks and see if investors can outperform the market.
Some Wide Moat Stocks Recommended By Analysts in 2012
- Novartis AG
- Exxon Mobil Corp.
- Apache Corp.
- ArcelorMittal SA
Does the idea of following Warren Buffett into wide moat stocks appeal to you? In a sense, you can say that they are among the best defensive stocks for these turbulent times.