Warren Buffett has a long and successful track record when it comes to generating high returns from investing in the stock market.
One of the key reasons for his success could be his focus on buying companies with wide economic moats. In fact, this is one of his key tenets of investing and forms a large part of his investment strategy.
By adopting a similar approach, it may be possible to reduce risk and generate high returns over the long run.
Warren Buffett’s focus on economic moats
When buying a company, Warren Buffett has historically looked for businesses with a competitive advantage over their peers. He terms this an ‘economic moat’.
An economic moat is clearly very subjective. One investor may have a different viewpoint than another on whether a specific company enjoys a competitive advantage over its peers.
However, it often includes those companies which enjoy strong brand loyalty that means their customer base is more likely to stick with their products. Or, it could be a business that has a unique product that sets it apart from rivals.
Similarly, a business with a lower cost base than its rivals may be able to generate higher profitability in the long run.
Of course, Warren Buffett has many years of experience in identifying companies with wide economic moats.
However, by comparing the financial performance of companies, their track records in a variety of operating conditions and contrasting their business models, an investor may gain an insight into whether they have a competitive advantage over peers.
Economic moats and risk/reward opportunities
Warren Buffett’s focus on economic moats could increase his return potential. For example, a business with a loyal customer base may be able to charge higher prices for its goods.
Similarly, lower costs or a unique product may equate to higher margins. Over time, they can allow a company to command a higher valuation and rising share price.
Meanwhile, companies with economic moats may also offer less risk than their peers. For example, they may enjoy more robust demand during periods of weaker operating conditions. This may help to support their bottom lines and could make them more financially sound than their peers.
This point may be especially relevant amidst current economic difficulties that may persist beyond the short run.
Buying stocks with competitive advantages today
Due to the uncertain economic outlook, it may be more difficult than usual to follow Warren Buffett’s strategy of focusing on companies with economic moats. It remains unclear which sectors and companies will prosper in what could be a very different economy post-coronavirus.
As such, building a diverse portfolio could be more important than ever. In doing so, an investor can maximise their returns and limit risk over the coming years.
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Motley Fool contributor Peter Stephens has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
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