Does the Company have Staying Power?

When you are looking to invest in a company for a long period of time, it is important that the business has what Warren Buffett calls an "economic moat," or a sustainable competitive advantage. While a past performance of strong profitability and robust revenue and earnings growth may constitute a solid castle, the long term investor must also determine whether the company has a wide economic moat that will protect it against competition and margin erosion. These competitive advantages are qualitative aspects of the business and can therefore be very difficult to identify. As a prerequisite to any moat analysis, you must have a good understanding of the inner workings of the company as well as how it fits into its industry. Here are some common examples of moats:

Brand Equity

A well-established and respected brand name is one of the most powerful tools to ensure long term profitability. Loyalty to Procter & Gamble's portfolio of billion-dollar brands such as Tide, Crest, and Duracell will ensure that they continue to outsell cheaper generic rivals for years to come. Also, a premium brand image such as that one that Apple has cultivated will allow it to charge high prices and reap fat margins on iPods, iPhones, and whatever other iThings they decide to sell in the future.

Network Effect

Imagine a snowball rolling down a hill, gathering mass and speed as it accelerates. The power of the network effect is essentially the same: as more people come to use its good or service, the more valuable that good or service will become. As the network builds, it becomes more and more difficult for competitors to break into the market. Microsoft's Office software and eBay's online marketplace are two examples of well-established networks. You must also be wary of network mirages and the risks that network effects entail. For example, network effects built on the internet can be more transient than you think. Those who think that Facebook's network is impenetrable should remember the rise and fall of AOL. Also, some physical network effects tend to bring regulation (the telecom industry) as they can create natural monopolies.

High Switching Costs

This competitive advantage occurs when it would cost the customer a lot of time, effort, and/or money to switch from one product or service to a competitor's. This allows a company to lock in customers, even if a competitor brings a slightly cheaper or higher quality product to market. For example, Autodesk's leading design software has become the standard for the architecture and engineering industry. Knowledge of the software is essential for success in these fields. It would be very expensive and time-consuming for a whole architecture firm to retrain their staff with an entirely new product.

Cost Leadership

While making something at a cost lower than your competitors may appear to be a straightforward strategy, it is actually tends to be the most complex. Many low-cost producers are borne from economies of scale; high fixed costs and low variable costs allow them to produce higher volumes at lower average costs. However it is usually a combination of factors that allows a company to maintain a low-cost competitive advantage. The most obvious example is Wal-Mart, which has the power to undercut its competitors by utilizing an innovative inventory and warehouse system, building massive superstores, and using its size and clout to negotiate with suppliers.

Other Examples

There are some companies that may not fit neatly under any umbrella, and others still that can fit under more than one.

• Intel maintains its huge market share by pouring tons of cash into R&D and manufacturing, thus allowing it to constantly develop better chips and bring them to market faster that its competitors. It also helps that it has one of the worlds most valuable and recognizable brands.
• Moody's Corporation is the world's largest provider of credit ratings of debt instruments. The SEC limits the number of players in the credit ratings industry, and since many loan agreements and investment funds require certain credit ratings, they have no choice but to give Moody's their business.
• In addition to possessing one of the most reputable brand names in banking, Goldman Sachs' moat lies mainly in the quality of its employees and their amalgamation into a successful corporate culture. They are able to attract and retain top talent and promote a philosophy of "long term greed," which translates into long term profits.
  

The list goes on. Essentially, the strength of each of these competitive advantages can be summarized by answering one question: how much would it cost a competitor to replicate the business? While it is impossible to calculate this figure exactly, a rough estimate will likely be enough. (In fact, the closer you can get to an exact number, the lower the probability that you have a wide moat business.) Nonetheless, any company that possesses one of these wide economic moats can be relatively assured that they will continue to have profitable businesses in the future.