Warren Buffett famously coined the phrase “economic moat” in the 1990s as a metaphor to describe a company’s competitive advantage (or lack thereof).

The Oppenheimer Main Street Fund® team has taken Buffet’s economic moat concept to heart and we use it as a key part of our investment process.

In a previous blog post we mentioned the four key tenets of our stock strategy in managing the Oppenheimer Main Street Fund. The first is maintaining an all-weather orientation. The second, which we discuss below, is focusing on companies with economic moats.

Some members of our team have spent considerable time researching competitive advantages and have concluded that these advantages come from five main sources:

1. Switching Costs. When it costs a customer either money or (more frequently) time to switch providers, it gives the existing provider leverage (e.g., Apple, where customer habits combined with the effort required to move apps and app data between platforms creates customer inertia).

2. Network Effect. A network becomes more valuable for all users the more users join the network. These tend to be “winner take all” circumstances (e.g., CME Group, a situation where to find liquidity and the lowest trading cost, buyers congregate where the sellers are, and vice versa).

3. Cost Advantage. When a company can provide a good or service at a lower cost than its competitors, it is able to generate a greater profit margin and/or provide more value to customers (e.g., Progressive, where cutting out agents and using direct marketing allows it to provide insurance at a lower cost than traditional agencies).

4. Intangibles. These include explicit barriers to competition, such as patents and government licenses, as well as less explicit (but no less valuable) advantages like brand names (e.g., Mondelez’s Oreo cookies and Trident gums can be sold at higher prices than generics).

5. Efficient Scale. This arises when there is a limited opportunity already being fulfilled i.e., “room for only one” (e.g., International Speedway, where there is no need for more than one NASCAR track in any given city).

While any analysis of a company’s economic moat starts with a qualitative assessment of a firm’s positioning, the proof also needs to be in the pudding quantitatively. Meaning, we look for companies that can consistently generate returns on invested capital in excess of the company’s cost of capital.

Why Competitive Advantage is a Key Tenet

There are a couple of reasons why focusing on companies with competitive advantages makes sense.

First, companies with moats tend to have high returns on their invested capital. Even if one buys a company with a moat soon before it goes out of favor with the stock market, the company may continue to compound in intrinsic value at above-average rates over the long term.

Second, companies with moats tend to have less severe downside scenarios than those that have no moat. As such, the companies with the advantages tend to be more predictable and we, as investors, can generally have greater confidence in our estimates of intrinsic value.

Lastly, the market tends to assume companies with moats will have their excess returns on capital return to the mean faster than they actually tend to do. Buying great businesses that look likely to stay great for the price of an average business is a winning strategy.

With all that said, we believe looking at competitive advantage alone is not sufficient to make an investment thesis. Even the best businesses can become overvalued by the market and/or run by poor managers.

That is why we also make sure to investigate two other key factors — management execution and stock valuation – before we make an investment in the fund. More on those aspects of our strategy in future blog posts.

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