Buffet Buys with Financial Moats...

05/06/2005 12:00 am EST

Focus:

Paul Tracy

Editor, The StreetAuthority Market Advisor

"In light of Warren Buffett’s recent meeting with shareholders, we would focus on one of his investment concepts economic moats," says Paul Tracy. Here, he looks at some financial companiesthat just like castlesare protected by their moats.

"In today's highly competitive modern economy, companies are not unlike medieval castles. A successful company that manages to earn sizable profits will undoubtedly attract competitors. So how do companies avoid that sort of economic siege? The most successful are those that boast some sort of sustainable competitive advantage and are able to maintain their success despite the inevitable attacks from competitors. Companies with wide economic moats operate business models that are difficult if not impossible for competitors to attack or emulate. We have searched for companies with wide economic moats. Although the exact source of their wide moats varies dramatically from firm to firm, all of these companies have the potential to keep their competitors at bay over the long haul. And while companies with economic moats appear in all industries, here we offer a few that are focused in the financial arena.

"Moody's (MCO NYSE) provides credit ratings as well as the analysis of credit and debt securities. Thanks to the fact that the credit ratings market is heavily regulated by the federal government, Moody's enjoys a wide economic moat. It would be extremely difficult for new firms to enter this market, and it's unclear if the government would even allow another competitor. Further reinforcing the company's moat, many loan covenants require borrowers to maintain a certain credit rating from Moody's. And many professional money managers are only allowed to invest in bonds with a certain rating by Moody's. Growth overseas is also pushing Moody's growth. In recent years, smaller European and Asian companies have entered into the market with high-yield bond issues. To attract investment from major institutional players these firms need to receive a rating from Moody's. Thanks to this enormous economic moat, Moody's should be able to sustain above-average growth of +15.0% over the long haul.

"First American Financial (FAF NYSE) offers real estate title insurance. Most lenders require this insurance prior to disbursing funds. First American also maintains an enormous consumer credit information database. Lenders need that type of valuable information in order to determine if a potential borrower represents a good credit risk. Because state regulators control the pricing of title insurance, there is little potential for increased competition in this business. On the credit information front, its database has been compiled over many years and from a variety of sources, and would be very difficult to replicate. Meanwhile, in order to offer the very best possible loan rates to consumers while not exposing themselves to excessive risk, banks must carefully examine credit information. With one of the most complete consumer databases in the country, that spells stable demand for FAF's database. The stock's long-term growth rate of +12% looks solid.

"Chicago Mercantile Exchange (CME NYSE) is the dominant futures and derivatives trading exchange in the US, as well as one of the largest exchanges in the world. CME specializes in the trading of stock market and interest rate futures and options. For every buy or sell order handled by the exchange, CME receives a small fee. The higher the volume, the more fees the firm collects. CME has used the network effect to widen its economic moat. Traders are attracted to volume because higher volume means better liquidity and, in turn, better execution prices. It would be extremely difficult for an upstart exchange to attract similar volume. Even better, the company has a lock-hold on the trading of certain contracts, such as the high-volume S&P 500 futures, which are licensed to CME. As for future growth, the company's all-electronic GLOBEX platform has delivered strong gains in recent years, and now accounts for the majority of the firm's trading volume. These higher-margin trades should help CME to post stellar gains for shareholders in the years to come.

"First Data (FDC NYSE) is one of the world's leading providers of credit, money transfer, and electronic payment processing services. It offers equipment that enables merchants to accept and process Visa and MasterCard credit cards. With a 75% share of the global money transfer business, Western Union is the company's most valuable franchise. Because the network is so large, dominant, and available globally, the franchise has a huge networking advantage, giving the company a wide economic moat. First Data also uses its enormous size and marketing muscle to move aggressively into new markets. For example, FDC has been an early mover in China. As the Chinese economy grows, so too will the need to transfer money. You can bet that FDC will eventually build a dominant position in this fast-growing market. The firm's credit processing business also benefits from large economies of scale, giving the company yet another wide economic moat.

"American Express (AXP NYSE) is best known for its signature charge card. The average American Express cardholder spends nearly $10,000 annually on his/her card, about twice that of the average Visa or MasterCard holder. This makes American Express customers far more valuable for merchants. For this reason, AMEX charges a transaction fee that is roughly a full percentage point higher than Visa and MasterCard proof positive of AMEX's wide economic moat. AMEX holds onto its valuable clientele in a number of ways, such as special rewards such as free travel insurance and theft protection. AMEX has also had considerable success with its Rewards points program and customers enrolled in this program tend to spend more and have better repayment records. Finally, AMEX does not rely on third-party credit processors; instead, it processes its transactions through its in-house network. And looking at the longer-term picture, emerging markets in Asia and Latin America should continue to see strong growth in credit card use, providing American Express with a large base of potential new customers."

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