Durable competitive advantage

Having some innate competitive advantage can mean a company is built to last, according to Buffett. A great example of this kind of advantage is a far-reaching distribution system, says Larry Coats Jr., a portfolio co-manager of the RS Capital Appreciation Fund (RCAPX) at RS Investment Management.

Kraft (KFT), a holding of both Buffett and Coats, expanded its distribution system on a global scale when it bought Cadbury, the candy company, in 2010. Now it can exploit that distribution system by using it to sell snack packs of products such as Oreos in places like India, says Coats. "One of the benefits Kraft got was a worldwide distribution network that gives it the ability to take these great brands and sell them throughout the world," says Coats.

Think of it this way: Having the Cadbury distribution network essentially means Kraft can move snacks from the back of grocery stores to the front counter at convenience stores. Kraft also has a moat in powerful brands that include Oscar Mayer, Oreo, Maxwell House, Nabisco Jell-O, Chips Ahoy and Kool-Aid.

Like Kraft, McDonald's and Coca-Cola have a lasting competitive advantage in their broad, global distribution networks. Coca-Cola sells drinks in nearly 200 countries, and it is investing billions to build out that network in high-growth areas such as China, Russia and Brazil, where soft-drink consumption is increasing along with the growth in incomes. McDonald's also continues to expand in emerging markets.

High profitability

Buffett looks for quality in companies by seeking out those that are the most profitable over the long term. To do so, he looks for companies with a return on equity of greater than 15% over the past three years, according to Validea. Return on equity measures how much profit a company generates on the money invested by shareholders. Buffett also looks for a return on total capital of more than 12% over the prior three years. Return on capital measures profits against both shareholder equity and debt.

IBM (IBM), a recent Berkshire Hathaway (BRK.A) purchase, passes both of those tests with flying colors. It has a return on equity of 64.9% over the past three years, and a return on capital over the past three years of 32%, says Validea. IBM also has a moat, because of the strength of its business software and related services, says Shueh, of Roundview Capital.

Pricing power

Having the power to raise prices is a sign that a company sells great products or is well-positioned in some other way. This is why Buffett loves companies with pricing power. It's a sign of quality.

Diageo (DEO), the world's largest distributer of beer and spirits, is a good example of a company with pricing power, says Todd Lowenstein, portfolio manager of the HighMark Value Fiduciary Fund (HMVMX).

Diageo has powerful brands including Guinness, Cîroc vodka, Tanqueray gin and Johnnie Walker whiskey. Lately, it's been taking advantage of the power of its brands and customer loyalty to raise prices.

Another example of such a company is Union Pacific (UNP), one of two main railroads serving the western half of the U.S. -- a near exclusivity that gives it the pricing power it enjoys. Buffett likes this kind of pricing power so much that he bought BNSF Railway, the other railroad serving this part of the U.S, in 2009.

For other companies with pricing power, take a look at this slide show.


Buffett loves dividends, and not just for the money. A dividend is a sign of quality. If a company's board feels so confident that it commits to paying a dividend, that's a signal that pretty steady earnings are ahead, because stocks typically get hit when a company misses a dividend payout or cuts it. All of the companies I've mentioned pay decent dividends, ranging from a low of 1.8% at IBM to 3% at Kraft and 3.2% at McDonald's.

When you own millions of shares of companies that pay dividends like these -- as Buffett does -- you can buy a lot of Cherry Coke.

Besides dividends, all of these companies -- McDonald's, Coca-Cola, Kraft, IBM, Diageo and Union Pacific -- have something else in common. They're all high-quality companies, because they have some competitive advantage like a moat, they're consistently profitable, and/or they sell products or services that customers either really need or really want, which gives them pricing power.

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So while I usually discourage people from investing on margin because it is so risky, borrowing a little money to boost returns by being in these quality names makes sense, especially during weak moments in the market -- like now.

At the time of publication, Michael Brush owned or controlled shares of the following companies or funds mentioned in this column: Coca-Cola. Brush is the editor of Brush Up on Stocks, an investment newsletter, which has recently suggested Coca-Cola as a purchase.

Michael Brush is the editor of Brush Up on Stocks, an investment newsletter. Click here to find Brush's most recent articles and blog posts.