It's never a bad idea to bullet-proof your stock portfolio with companies that have a clear-cut competitive advantage.
And now may be the right time to bolster your defenses with exchange-traded funds (ETFs) that buy stocks of companies with so-called "wide moats."
Of course, famed investor Warren G. Buffett originally coined the term to describe companies with distinct competitive advantages over other firms in its industry.
The Oracle of Omaha says he is always looking for "economic castles protected by unbreachable moats."
Indeed, Buffett's Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B) is chock full of wide-moat companies that consistently rake in high returns on invested capital, propelling their shares higher year after year.
The idea is to buy — when they are cheap — shares of companies that have dominant positions in their industries and are likely to maintain their superiority for decades, not months or years.
For example, Berkshire has held positions in The Coca Cola Co. (NYSE: KO) and Exxon Mobile Corp. (NYSE: XOM) for decades, patiently reaping the rewards from their wide moats.
"A company that has a greater duration of competitive advantage is simply worth more," Paul Larson, chief equity strategist at investment research firm Morningstar Inc. (Nasdaq: MORN) told MarketWatch.
So what gives one company a wide moat while others try to scrape by on the leftovers?
Here's what gives them the upper hand…
What Kinds of Companies Have Moats
Simply put, companies with wide moats have competitive advantages that create high barriers to entry and discourage competition.
A good example would be pricing power, where a company has cheap access to raw materials.
Other companies with wide moats include service firms that deliver unparalleled quality or businesses with global brand name recognition. Still others might have a virtual monopoly in a small market or own patents and licenses that provide steady cash flow.
Common examples are strong brand names like McDonald's Corp. (NYSE: MCD), patent-rich drug companies like Pfizer Inc. (NYSE: PFE), or the exclusive cable TV franchises awarded to companies like Time Warner Cable Inc. (NYSE: TWC).
Any industry could have a wide-moat company.
But the wider the moat, the better, Eric Schoenstein, co-manager of Jensen Quality Growth (MUTF: JENXS), told The Wall Street Journal.
He loads his portfolio with under-priced companies featuring wide moats, including Praxair Inc. (NYSE: PX), an industrial gas supplier, and Varian Medical Systems Inc. (NYSE: VAR), a maker of devices and software for treating cancer and other illnesses.
Companies with wide moats produce a lot of cash, which places them "in a better position to invest in new products, new advertising, to create more demand," he says
Morningstar found that only 10% of the 2000 or so publicly-traded stocks it covers have a moat wide enough to provide a sustainable competitive advantage for 20 years or more, Larson told Barron's.
Roughly 50% have relatively narrow economic moats that will stave off competitors for at least a decade. The remaining 800 have no moat at all.
Still, owning "wide-moat" companies is not a guarantee against tough economic times and market swoons.
But they are more likely ride out the rough spots better than their competitors. And when the recovery finally comes, shares of companies with wide moats are likely to lead the charge higher.
Where to Invest
In an effort to identify the cheapest wide-moat stocks Morningstar created a Wide Moat Focus Index in 2007. The index combs through 1200 U.S. companies every quarter to identify the 20 with the least expensive shares. They tend to be large cap firms with a broad customer base.
Currently, the good values are in technology, materials and financial-services stocks, while the consumer sector brings up the rear.
Top holdings include Google Inc. (Nasdaq: GOOG), Vulcan Materials Co. (NYSE: VMC), Northern Trust Corp. (NYSE: NTRS), Oracle Corp. (Nasdaq: ORCL) and Express Scripts Holding Co. (NYSE: ESRX).
And the strategy is paying off — in spades.
The index gained 7.4% annualized over the last five years including dividends, while the S&P 500 posted a paltry total return of 1.1%.
In fact, shares of companies with the widest moats have outpaced the S&P 500 by more than six percentage points a year over the past five years, Morningstar says.
Investors who are want to add a moat around their portfolio might take a look at the recently launched Market Vectors Morningstar Wide Moat Research ETF (NYSEArca: MOAT) and the Deutsche Bank Elements Morningstar Wide Moat Focus ETN (NYSEArca: WMW).
Keep in mind, however, that even wide-moat companies can eventually lose their edge to rivals with better technology or management.
In other words, moats can provide a safe harbor for a period of time, but they probably won't be on top forever.
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