Companies with Unique Advantages are Resilient in Downturns

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Warren Buffett has often talked about investing in companies that are protected by “wide moats.” Such businesses dominate their markets for years because of advantages that competitors cannot duplicate.

A longtime Buffett favorite is Coca-Cola. With its familiar brand and worldwide distribution network, the soft-drink giant can defend its position from the challenges of competitors. Another unassailable company is Microsoft, which provides software for most personal computers. The software giant has $30 billion in cash, enough to support growing operations for years.

For cautious investors, companies with wide moats can make ideal investments. The businesses can report consistent profits, and the shares tend to be relatively resilient in downturns.

To help investors spot solid choices, Morningstar, an investment research firm, rates 2,000 stocks according to the size of their moats. In order to be ranked in the wide-moat category, a stock must have high returns on capital that can be attributed to factors such as patents or huge economies of scale. Companies with no moats have weak profits and stiff competition. Many of Morningstar's wide-moat stocks are blue chips with famous brand names, including 3M, American Express, Campbell Soup, and Exxon Mobil.

A wide moat focus

To take advantage of the Morningstar rating system, consider buying Elements Morningstar Wide Moat Focus Total Return Index, an investment note that trades on stock exchanges. The Elements investment tracks an index that includes stocks picked by Morningstar. Among the holdings are Harley Davidson, the motorcycle company that is known for retaining loyal customers, and Time Warner Cable, which has the cable-TV franchise for lucrative New York markets. During the past year, Elements Morningstar has returned 29.5%, outdoing the S&P 500 by 19 percentage points.

Emulating Buffett, some mutual funds focus on wide-moat stocks. Many of the funds have produced strong long-term records. Such wide-moat funds can be attractive choices that help to anchor a portfolio.

Morningstar recently studied the wide-moat funds and found that they proved relatively steady during the recent downturns. For the study, Morningstar researchers rated funds according to the number of wide-moat stocks they held. Of the 18 funds with the highest concentration of wide-moat stocks, 17 outperformed their categories by comfortable margins during the downturn of 2008. Funds with strong performance in 2008 include JHancock Large Cap Select, Wells Fargo Advantage Large Company, and AMF Large Cap Equity.

Top performing funds

Among the top-performing wide-moat funds has been Jensen Fund. The Jensen managers consider only stocks that have produced returns on equity of at least 15% for 10 consecutive years. That is a steep hurdle. Of the approximately 10,000 publicly-traded stocks, only about 200 pass the test. Why does the fund focus on this small group? The Jensen managers say that members of the elite group are enormously profitable. Only companies with strong competitive advantages can generate such consistent earnings. The powerhouse businesses are likely to continue being profitable for years to come.

To avoid overpaying, the Jensen managers buy strong companies that have temporarily moved out of favor and sell at discounts. A top Jensen holding is Procter & Gamble, which makes Tide Detergent, Crest toothpaste, and Gillette razors. By seeking to develop superior products, the company has long maintained a secure grip on its customers.

Another wide-moat fund is Oak Value, which has returned 2% annually during the past decade, outdoing the S&P 500 by 2.9 percentage points. The Oak Value managers seek high-quality companies that sell at discounts of 30% or more from their fair values. The managers often watch dominant stocks for years, waiting patiently until the share prices dip into discount territory. 

For more than 15 years, Oak Value manager Larry D. Coats Jr followed Colgate-Palmolive, the wide-moat maker of soap and toothpaste. Coats recognized that the company had a long track record of reporting hefty profit margins, but the stock was always too rich for his taste. Finally, during the downturn early this year, the shares dropped to discount range, and Oak Value began buying.

Thriving for years to come?

Coats argues that Colgate can continue thriving for years to come. The company boasts a famous brand and legions of loyal customers. Sales are growing rapidly in the emerging markets of Asia and Latin America, where millions of consumers are entering the middle class and spending more on health products.

Another stock that Coats holds is Automatic Data Processing Inc. (ADP), which dominates the market for managing payrolls. Large companies turn payroll cash over to ADP, which oversees the money and sends checks to employees. Employers could do the task themselves, but it is cheaper to hire ADP because of its economies of scale. ADP's revenues tend to be steady because it signs long-term contracts with employers.

Since ADP is paid a fee for each paycheck that it handles, investors have feared that rising layoffs could shrink the company's revenues, and the shares dipped this year. But Coats isn't worried. Because ADP helps companies cut costs, it should retain a firm grip on its niche and gain market share during the recession.

To own small and mid-cap stocks with wide moats, consider FBR Focus, which has returned 12% annually during the past decade. The fund aims to buy growing companies and hold them for years. A favorite holding is Penn National Gaming Inc., a casino operator. Plagued by the recession, casinos are struggling in the fiercely competitive markets of Las Vegas and Atlantic City. But Penn National's revenues have proved resilient because the company dominates the action in secondary cities, such as Sioux City, Iowa, and Baton Rouge, Louisiana.

Another wide-moat holding is American Tower, which operates 23,000 towers used to transmit wireless calls. Wireless companies pay rent in order to use the towers. In many local markets, American Tower has a near-monopoly. Once one tower is built, it can be difficult to put another nearby because many homeowners fight to block construction in their neighborhoods. While construction may be delayed, demand for wireless service continues climbing. That should ensure American Tower's ability to remain richly profitable for years to come. 

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