I have tried a lot of different approaches to picking good shares to invest in over the last ten years. From buying shares in small-cap growth companies to 'bargain' commodity producers.
The most successful approach I've found when picking shares has actually been one of the simplest: looking for companies with strong economic moats.
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What is an 'economic moat'?
An 'economic moat' is another name for a competitive advantage. It is a feature that is hard to replicate which protects a company's earnings from the onslaught of competition. Just like a moat protects a castle.
Companies with economic moats can be an investors' best friend. By being insulated from competition companies, they are able to generate above-average returns on capital. By reinvesting that cash, these companies can compound and grow dramatically over time.
Many of the best-performing ASX-listed companies have strong economic moats. If we pick these companies as a core part of our portfolio, we stand a good chance of earning better returns.
The 4 types of economic moat
In his book 'The Little Book That Builds Wealth' author Pat Dorsey outlines four categories of economic moat to look for when picking a company to invest in:
- Intangible assets
- Customer switching costs
- The network effect
- Cost advantages
Intangible assets can include brands and patents. Blood product company CSL Limited (ASX: CSL) is an example of a company which, through years of research and acquisitions, has created a valuable portfolio of patents and product licences.
Accounting platform Xero Limited (ASX: XRO) is an example of a company with high customer switching costs. Because there is a lot of time and hassle involved with changing to a new accounting system, the cost to switch can be prohibitive.
Despite the rise of Linkedin, jobs platform Seek Limited (ASX: SEK) has proved to be a robust example of the network effect where growing additional users creates more value for other users.
While JB Hi-Fi Limited (ASX: JBH) is an example of a company that has thrived using cost advantages to reduce prices for consumers and win market share.
Growing your money with great companies
I think economic moats are useful criteria for picking decent companies that will earn high share returns. However, to really get the best result we need to have patience; the patience to buy shares at bargain prices and the patience to let returns compound for long periods. That is the hard part.
