Warren Buffett’s Secret For Picking Great Stocks: "Moat" Investing

One of Warren Buffett’s greatest investment ideas concerned “economic moats.”

What he meant by this was to invest in companies with significant competitive advantage that stops competitors from breaking into their market share. These competitive advantages served as “moats” around these businesses, much as a moat of water would protect a castle from intruders in medieval times.

To consider how “moat” investing works in the real world, let’s consider McDonalds (MCD).

For starters, MCD has a moat. MCD was launched in 1940. Burger King was launched in 1953. Wendy’s was launched in 1969.

Despite these competitors moving into its space, MCD has thrived, growing to become the largest hamburger based business in the world: its 2012 revenues were $27 billion compared to Burger King’s $1.9 billion and Wendy’s $2.5 billion.

Today, MCD has over 34,000 restaurants based in 199 countries employing 1.8 million people. Obviously the company is able to defend its market share from competitors. That’s an economic moat.

Between this and the company’s focus on producing returns to shareholders, those who invested in MCD and held for the long-term have dramatically outperformed the market and built literal fortunes.

Indeed, had you in McDonalds in 1986, you would have outperformed the S&P 500 by a simply enormous margin (see Figure 1 below). Not only that but you would have crushed every asset manager on planet earth with very few exceptions.

Regarding returns to shareholders, MCD has paid dividends every year for 37 years and has increased its dividend at least once per year.

Dividends per share have increased from $0.11 in 1986 to $2.87 in 2012. Those who invested in MCD shares in 1986 are receiving a yield of nearly 30% per year on their initial investment today just from dividends alone.

MCD is so focused on producing returns for shareholders that the company has bought back 23% of its shares outstanding in the last ten years. So even investors who bought in 2000 have experienced a synthetic yield of roughly 5% per year.

However, the most dramatic returns produced by “moat” investing are evident through the power of compounding as illustrated by MCD’s Dividend Re-Investment Plan or DRIP (a plan through which cash dividend payouts were automatically used to buy more MCD shares).

If you had invested in MCD’s DRIP program in 1988, you would have turned $1,000 into over $23,000 by the end of 2012. This is not by adding to your positions, this is the result of one single $1000 purchase of MCD stock.

This example of “moat” investing is precisely the kind of wealth generating investment that has made Warren Buffett a billionaire.