That’s how Warren Buffett defines a great company — and so should you

A strong bull market over many years may have given some investors the wrong impression that everything is going up. For a while, that’s what happened, with some growth stocks skyrocketing in price with percentage gains into the thousands. It just looked because it was.

Many new investors have never experienced a bear market, but many of those early gains have now been wiped out completely. Turns out, accumulating wealth overnight or over months may not be that easy.

A consistent voice of reason through decades of ups and downs is guru-investor Warren Buffett, who has beaten the market with his value-based approach. He’s always worth listening to, but in this type of market it makes even more sense to remember what he’s looking for in a stock. There are several factors that influence his decisions, but one stands out in his definition of a great company.

What is a moat?

Buffett says, “A truly great company must have an enduring “moat” that protects excellent returns on invested capital.” The “moat” he speaks of refers to a competitive advantage that makes the company unique and better than others power. In the truest sense of the word, a moat protects a castle from incoming attacks. In the markets, a moat protects a company from challengers.

There are several parts to this formula. One of them is that the moat must be permanent. If this is not the case, it offers no real protection. It must also protect excellent returns on invested capital, which means that they must exist in the first place. If a company appears differentiated but isn’t performing and achieving excellent results, the business will fall apart despite all apparent benefits.

Some excellent examples

Buffett continues:

The dynamics of capitalism ensure that competitors will always attack any business “fortress” that generates high returns. Therefore, a formidable barrier, such as For example, the fact that a company is a low-cost producer…or has a strong global brand…is essential to sustained success.

He gives several examples. Geico (owned by Buffett’s holding company, Berkshire Hathaway) and Costco Wholesale both operate a discount model that is convincingly better than the competition. That’s a moat because they’re both hard to challenge.

When it comes to a strong, global brand, he leads Coke (KO 0.72%) as an an example. Despite years of taste testing and debates about whether Coca-Cola is better than your local off-brand, Coca-Cola can command high prices and loyal customers respond. Coca-Cola remains the largest beverage brand in the world by revenue, and its unbeatable brand is a robust revenue generator that delivers excellent returns on invested capital.

Buffett also mentions American Express (NYSE:AXP) than having a moat in his mighty mark. It has a premium image with real benefits that attract an affluent clientele. Other credit card companies that serve a wider range of customers don’t carry the same seal of approval.

Stronger moats lead to better stocks

Finding companies with real moats can lead to higher long-term profits. Buffett made these comments more than 15 years ago, and the examples he cites actually stand. Coca-Cola and American Express remain two of his top holdings, and they’ve produced stellar results in an otherwise weak market and volatile economy. Their brands endure over time and want to carry their companies far into the future. Buffett sold his position in Costco in 2020, but it also remains a top stock. Although only Coca-Cola stock has posted a gain so far this year, all of these stocks are outperforming the market.

AXP chart

AXP data from YCharts

A strong moat is a sign of great business. Building it requires a great business, a competitive advantage, and the ability to sustain that advantage over the long term. Shifting your focus to investments that exhibit these qualities rather than searching for the next hot growth stock can lead to more successful long-term investments.

American Express is an advertising partner of The Ascent, a Motley Fool company. Jennifer Saibil has positions at American Express. The Motley Fool has positions in and recommends Berkshire Hathaway (B shares) and Costco Wholesale. The Motley Fool recommends the following options: long January 2023 $200 calls on Berkshire Hathaway (B shares), long January 2024 $47.50 calls on Coca-Cola, short January 2023 $200 puts on Berkshire Hathaway (B shares) and short January 2023 $265 calls on Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.

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