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Something Warren Buffett is always on the lookout for when evaluating potential investments is whether or not they have an economic moat around the business.

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According to Buffett, a competitive advantage allows a business to maintain it’s pricing power and produce better than average profit margins.

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An economic moat translates into more significant returns for investors over time, as companies can return more capital to their investors.

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Buffett first explained his economic moat principal back at the 1995 Berkshire Hathaway annual meeting of shareholders.

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"What we're trying to do, is we're trying to find a business with a wide and long-lasting moat around it, surround -- protecting a terrific economic castle with an honest lord in charge of the castle." - Warren Buffett

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Buffett looks for these things in an economic moat:

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"What we're trying to find is a business that, for one reason or another -- it can be because it's the low-cost producer in some area, it can be because it has a natural franchise because of surface capabilities, it could be because of its position in the consumers' mind, it can be because of a technological advantage, or any kind of reason at all, that it has this moat around it." - Warren Buffett

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When he's found a business with a large moat around it, the next stage in Buffett's process is to try and figure out what's keeping the moat intact:

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"But we are trying to figure out what is keeping -- why is that castle still standing? And what's going to keep it standing or cause it not to be standing five, 10, 20 years from now. What are the key factors? And how permanent are they? How much do they depend on the genius of the lord in the castle?" - Warren Buffett

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Once Buffett have established the above factors, the next stage is to establish how capable the company's manager is:

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"And then if we feel good about the moat, then we try to figure out whether, you know, the lord is going to try to take it all for himself, whether he's likely to do something stupid with the proceeds, et cetera." - Warren Buffett

 

The three-step process

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That's the three-step process Buffett said he used to evaluate businesses back in 1995 hasn’t changed much since. It continues to revolve around finding businesses that have a strong moat or competitive advantage.

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The three steps then is to:

1. Find companies with strong economic moats

2. Establish how strong the moat is and if the company will still be strong in one or two decades. You want companies that continue to buy investors back in the form of increasing dividends.

3. The final stage is to assess the quality of management.

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If all three of the above provide a positive result, you can look to invest in a business at a discount valuation, what Buffett famously calls “A Margin of Safety”.

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Warren Buffett likes a margin of safety of over 30%, meaning the stock price could drop by 30%, and he would still not lose money. All value investors need to understand that the margin of safety is only an estimate of a stock's risk and profit potential.

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Warren Buffett once said, “The first rule of an investment is don't lose money. And the second rule of an investment is don't forget the first rule. And that's all the rules there are.”

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