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Find Economic Moats
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What separates a bad company from a good one? Or a good company from a great one?

In large part, it's the size of the economic moat a company builds around itself. The term economic moat is used to describe a firm's competitive advantage—in the same way that a moat kept invaders of medieval castles at bay, an economic moat keeps competitors from attacking a firm's profits.

In any competitive economy, capital invariably seeks the areas of highest expected return. As a result, the most profitable firms find themselves beset by competitors, which is why profits for most companies have a strong tendency over time to regress to the mean. This means that most highly profitable companies tend to become less profitable as other firms compete with them.

Economic moats allow a relatively small number of companies to retain above-average levels of profitability for many years, and these companies are often the most superior long-term investments. Longer periods of excess profitability lead, on average, to better long-term stock performance.

Identifying economic moats is such a critical part of the investing process that we'll devote an entire chapter—Chapter 3—to learning how to analyze them. Here's a quick preview. The key to identifying wide economic moats can be found in the answer to a deceptively simple question: How does a company manage to keep competitors at bay and earn consistently fat profits? If you can answer this, you've found the source of the firm's economic moat.

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