Warren Buffett has had a long and successful investing career. He started out by focusing on value stocks, or companies that were selling for less than they were really worth. There were lucrative profits to be made by flipping investments in this way. But once he met Charlie Munger, Buffett refocused his efforts on finding quality companies.
This is what Warren Buffett said of the companies he looks for: “What we’re trying to do is we’re trying to find a business with a wide and long-lasting moat around it, protecting a terrific economic castle with an honest lord in charge of the castle.”
Here are two companies that match this description I’d buy today.
A strong network effect
Auto Trader (LSE: AUTO) is the UK’s biggest online marketplace for vehicles. For this reason, the company has a strong network effect, which I think forms the economic moat around its castle. Network effects are particularly good economic moats because they result from a high number of active users which is hard for a competitor to copy.
In particular, Auto Trader benefits from a large number of users looking to buy vehicles on its online platform. Therefore, car retailers and private sellers want to list their vehicles on the platform to reach the biggest audience. Auto Trader becomes more valuable as a business the more users it has. What’s more, every additional user comes at little incremental cost to the business.
I think this network effect shows in Auto Trader’s excellent profitability ratios. For example, the company achieves an operating margin of over 60%. This is the second-highest operating margin in the FTSE 100 today.
There are still risks to consider. Any slowdown in the UK economy will impact the sales of vehicles. The company isn’t fully immune to competitors, either. Other companies, such as Cinch, are investing heavily in advertising to try and take market share from Auto Trader.
Nevertheless, I consider the stock a buy for my portfolio.
Another business with a Warren Buffett moat
The next company is Rightmove (LSE: RMV), the online marketplace for the UK housing market. In many ways, it demonstrates the same network effect as Auto Trader, only this time for homebuyers and renters. Because its online property portal is the most widely used in the UK, homebuilders and estate agents must list properties on Rightmove so they gain access to this big audience.
Rightmove’s economic moat is again shown in the company’s outstanding profit measures. It achieves the highest operating margin in the whole of the FTSE 100 at 66%. Furthermore, it generates triple-digit returns on its equity, which is abnormally high for a company.
One factor to consider for the company is the strength of the UK’s housing market. Rightmove is only based in the UK, so any slowdown in home-moving would lead to reduced profits. This happened during 2020 when the pandemic unfolded. As a consequence, revenue fell 29% across the full year.
The company is in a better position today, in my view. For example, the UK’s housing market has been strong in 2021, so analysts are expecting revenue growth of 47% across the full year.
So, for me, I think Rightmove and Auto Trader are two quality UK companies due to their network effects. In Warren Buffett’s words, I think they have economic moats, and I’d buy the shares today.
Dan Appleby owns shares of Auto Trader and Rightmove. The Motley Fool UK has recommended Auto Trader and Rightmove. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
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