Here’s how Warren Buffett defines a great business — and how you should

A multi-year strong bull market may have misled some investors into thinking that everything was going up. That’s been pretty much the case for some time now, with some growth stocks surging in price, with percentage gains in the thousands. It looks easy because it is.

Many new investors have never experienced a bear market, but many of those early gains have now been completely wiped out. It may not be easy to build wealth overnight or in a few months, as it turns out.

A consistent voice of rationality through decades of ups and downs has been investment guru Warren Buffett, who beat the market with a value-driven approach. It’s always worth listening to what he has to say, but in this kind of market it makes more sense to jot down what he’s looking for in stocks. Several factors influence his decision, but one factor stands out in how he defines a great business.

What is a moat?

“A truly great business must have a lasting ‘moat’ to protect excellent returns on invested capital,” Buffett said. By “moat,” he refers to a competitive advantage that sets a business apart and outperforms others. it is good. Literally, the moat protects the castle from oncoming attacks. In the marketplace, a moat protects a business from challengers.

This formula has several parts. One is that the moat must be durable. If it isn’t, it’s not really protection. It must also protect excellent returns on invested capital, which means those returns are needed in the first place. If a company looks different but underperforms and doesn’t post great results, the business will fall apart despite any seeming advantages.

some good examples

Buffett went on to say:

The dynamics of capitalism guarantee that competitors will repeatedly attack any commercial “castle” that earns high returns. Therefore, huge obstacles such as a company becoming a low-cost producer…or having a strong global brand… are critical to continued success.

He gave a few examples. Geico (owned by Buffett’s holding company, Berkshire Hathaway) and Costco Wholesale Both use better discount models than the competition. That’s a moat because they’re all hard to challenge.

As for a strong global brand, he cites Coca Cola (KO 0.72%) for example. Despite years of taste testing and debate about whether Coca-Cola is better than a local off-brand, Coca-Cola can command premium prices, and loyal customers will respond. Coca-Cola remains the world’s largest beverage brand by sales, and its unrivaled brand is a strong sales driver that drives strong returns on invested capital.

Buffett also mentioned American Express (NYSE: AXP) Like having a moat in its strong brand. It has a premium image and real perks that attract wealthy clients. Other credit card companies that cater to a broader customer mix don’t have the same prestige.

Stronger moats lead to better inventory

Finding businesses with real moats can lead to higher long-term returns. Buffett made these remarks 15 years ago, and the examples he cites really endure. Coca-Cola and American Express remain two of his top holdings, which have done well in otherwise sluggish markets and a volatile economy. Their brand is enduring and they want to take their company into the future. Buffett sold his position in Costco in 2020, but it’s still a top stock. While only Coca-Cola stock has risen so far this year, all of them have outperformed.

AXP data on YCharts

A solid moat is the hallmark of a great business. Building a business requires a great business, a competitive advantage, and the ability to strengthen that advantage over the long term. Shifting your focus to investments that exhibit these qualities, rather than finding the next hot growth stock, can lead to more successful long-term investments.