'Moats' add might to investment returns

In the Middle Ages, moats were deep, water-filled trenches that encircled castles to protect kings. The wider, the better.

In 2007, moats are the competitive advantages that protect dominant companies and their shareholders. The wider, the better.

The goal in trying to pick companies with wide moats is to give investors the security of knowing that a firm isn't likely to see its products or services overtaken by rivals.

Although many of these companies are king-size, some smaller niche players qualify, too. Of course, the trick is not to pay too dearly for a stock to obtain this higher level of confidence.

"Very few moats are impenetrable, but some are certainly more durable than others," said Nathan Slaughter, editor of StreetAuthority.com's Half-Priced Stocks newsletter. "To evaluate how long a competitive advantage might remain before it begins to crumble, identify the factors that provided the moat in the first place."

For example, the bulk of cash generated by the vacation cruise industry flows directly to Carnival Corp. (CCL) and Royal Caribbean Cruises Ltd. (RCL), Slaughter said. Because it costs more than $500 million to build a luxurious new cruise liner these days, it would be daunting for any competitor to enter that game.

Similarly, in the refuse business, Waste Management Inc. (WMI) enjoys a wide moat because it owns more government permits for solid-waste landfills than its three closest rivals combined, he said.

Investors must remain on guard for competitive change. Consider that the operating income earned by casino operator Harrah's Entertainment Inc. (HET) at its Atlantic City resorts plunged nearly 38 percent in the second quarter, due to the introduction of competing slot machines in new jurisdictions in nearby New York and Pennsylvania, Slaughter said.

"A company's moat is important, but consider it just one investment metric, one arrow in the quiver," said Jeffrey Saut, chief investment strategist for Raymond James & Associates in St. Petersburg, Fla. "It is not the golden fleece."

Many motorists are hooked on global positioning systems for accurate directions, which has turned Trimble Navigation Ltd. (TRMB) and Garmin Ltd. (GRMN) into investment home runs. But GPS is proliferating, and generic competitors are surfacing. With pricing coming down and profit margins being compressed, Saut chose a different tactic.