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The 1 Warren Buffett Concept Investors Need to Understand

There are a great many reasons for star investor Warren Buffett’s runaway success. Although many of his triumphs come from his unusually sharp, ahead-of-his-time stock-picking ability, he does have a few straightforward, easy-to-understand principles that dominate his approach to finding great companies.

Among these, one stands out for its clarity and power. Not surprisingly, Buffett himself put a name to this concept, which he’s used throughout his long career to achieve stellar returns. We can’t promise that you’ll become a billionaire like the great man if you put it into action, but it’ll certainly help you pick out stocks with high potential.

Protecting the castle

“The economic moat” expertly distills a belief into a very clear visual. Just as a real-world moat surrounds and defends a castle from outside attack, an economic moat is a competitive advantage strong enough to withstand heavy competition.

Examples of this abound. Quick, what operating system powers your PC at work and at home? Unless you’re among the minority of people who regularly uses an Apple computer, that answer is almost certain to be Microsoft. That’s why the American company rose to such heights of profitability and prominence at the end of the 20thand beginning of the 21stcentury. Any person or business with even one PC needed an operating system to run it, and there were few easy alternatives to Windows. Even today, in an age of smartphones and tablets, the PC is an indispensable productivity tool, and Microsoft remains the default operating system of choice. That is a deep and wide economic moat.

Berkshire Hathaway’s portfolio is stuffed with companies that have wide moats. There’s American Express, which despite heavy competition is considered by many to be the high-end credit card issuer and payment network. Also on that list is Sirius XM Holdings, the one and only publicly traded company in the satellite radio business. As is UPS, the logistics company that is a constant presence on American roads, and top retail credit card issuer Synchrony Financial.

Find your own moat

It’s safe to say that most of us are not financial prodigies like Warren Buffett. Still, we can easily apply his basic core principle to our own investments. When you’re determining whether an investment has a sufficient moat, it’s helpful to ask a few questions:

  • Are any of its competitive advantages hard to replicate?
  • Is the company “the only game in town” for a particular product or service?
  • Does its leading product or service have brand recognition far stronger than any competitor?
  • Does the company enjoy clear and sustainable cost advantages over the competition that allow it to consistently undercut its rivals?

If the answer to one or more of these questions is “yes,” you’re looking at a business with a moat. These companies tend to reliably deliver strong economic performances, thanks to their advantage(s). In the best cases, it’s almost impossible for them not to net high profits year after year. The ever-quotable Buffett once put it in humorous terms when discussing of one of his favorite types of enterprises to buy, network TV operators. With this kind of company, he said, “You could put in a shiftless and backward nephew to run things, and the business would still do well for decades.”

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Disclosure: Eric Volkman doesn't own any shares mentioned. Motley Fool Hong Kong is not licensed by the Hong Kong Securities and Futures Commission to carry out any regulated activities under the Securities and Futures Ordinance.