One of the best investing books I think you can read is Pat Dorsey’s The Little Book That Builds Wealth.
The book is an excellent guide for identifying businesses with robust economic moats or competitive advantages. Economic moats surround many of the best-performing companies in the world. Companies like Apple (NASDAQ: AAPL) and Xero Limited (ASX: XRO). Companies that we wish we had discovered a decade ago!
Why you should own businesses with economic moats
In his book, Dorsey explains how economic moats protect companies from the fierce attack of competitors to help them to earn above-average returns on the cash they invest:
“Just as moats around medieval castles kept the opposition at bay, economic moats protect the high returns on capital.”
If a company has less competition it can charge a higher price for its products and spend less money on marketing. Now, imagine owning a portfolio full of companies like this, earning high returns year-in, year-out. What impact could that have on your wealth?
What are intangible asset moats?
One important economic moat which can be difficult to spot is the intangible asset moat.
Intangible assets are things like brands, patents and regulatory licenses which cannot be easily matched by competitors. These can create what Dorsey calls, ‘mini monopolies’. They prevent competitors from making and selling the same products and provides the company with pricing power.
3 companies with strong intangible asset moats
Blood product company CSL Limited (ASX: CSL) is an example of a company with a strong intangible asset moat. Through research and development, as well as acquisitions, CSL holds the rights to produce and sell lifesaving medicines and immunotherapies.
These rights aren’t impenetrable. Patents can be challenged and have a finite life. However, because CSL has a diverse portfolio of products, rather than relying on a single product, the moat is far more robust.
Fisher & Paykel Healthcare Corp Ltd (ASX: FPH) is another company supported by a moat of patents. The Fisher & Paykel Healthcare share price has surged over 300% in the last 5 years and the respiratory device manufacturer has been known to battle with rival ResMed Inc (ASX: RMD) over patent infringement.
If patents are the moat around the castle, regulatory licencing is the crocodile swimming in the waters. Regulatory licencing increases the barrier to entry for healthcare companies like CSL. It does this by requiring products to get regulatory approval for sale, but with no restriction on what price products can be sold for.
Finally, milk product company A2 Milk Company Ltd (ASX: A2M) is an example of a company with a growing brand for which customers are willing to pay a premium. Along with an impressive supply chain, the a2 milk brand is very hard for competitors to replicate.
Although intangible assets are hard to see, they can create valuable economic moats that help us to build wealth. A great way to test if an intangible asset gives a company true protection is to ask, “does it give the company pricing power and is it sustainable?”
To get you started, we've picked 5 more companies with the potential to develop strong moats in the years to come. Check them out for FREE in the link below...
5 stocks under $5
We hear it over and over from investors, "I wish I had bought Altium or Afterpay when they were first recommended by The Motley Fool. I'd be sitting on a gold mine!" And it's true.
And while Altium and Afterpay have had a good run, we think these 5 other stocks are screaming buys. And you can buy them now for less than $5 a share!
*Extreme Opportunities returns as of June 5th 2020
Regan Pearson owns shares of A2 Milk and Xero.
You can follow him on Twitter @Regan_Invests.
The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of CSL Ltd. and Xero. The Motley Fool Australia owns shares of A2 Milk. The Motley Fool Australia has recommended ResMed Inc. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.
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