Moats have been traditionally associated with castles. But as an investment concept, it was first pioneered by Warren Buffett. Morningstar recently launched a book on moats. Co-author of the book and CEO of Australian business, Heather Brilliant, discusses moats with Morningstar Australia’s online editor Christine St Anne. Below is an excerpt from the interaction.
How moats and valuations matter
A moat is a sustainable competitive advantage and we are just trying to capture the idea that a company can earn excess returns for a long period into the future. Moats matter because they can really help identify high-quality businesses that can make great long-term investments.
We rate companies as either having a wide moat, which is very hard to attain and very few companies globally have a wide moat rating. We expect a wide moat company to earn excess returns for the next 20 years or so. We also rate companies as narrow moat, which means that we expect the business to earn excess returns for the next 10 years or so. Then, the vast majority of companies have no moat, and that’s where even if they are earning excess returns now, we don’t expect it to persist long into the future.
So we do think it behooves investors to focus on wide and narrow moat companies when formulating portfolios, particularly because it really helps sort out companies that may not be around in the long-term or may not earn those returns that you are looking for as an investor.
That said, valuation is a critical component of investing success and we have found that throughout our decade plus research on investing in moaty companies. So, we do think that trying to buy these companies when they are trading at a discount to their fair value is really important consideration.
Key measures used in determining whether a company has a moat
On a quantitative basis, we really look for returns on invested capital to exceed the cost of capital and then we're just trying to get an overall picture of the profitability of the company and how well it can earn a return on the assets that it puts back into the business.
On the qualitative side, we're really looking for one of five factors.
1) The presence of intangible assets, that allow a company to either charge more than competitors or differentiate themselves in some way;
2) Switching costs;
3) A cost advantage or an ability to produce a good or service at a lower cost than competitors;
4) A network effect, which is really the idea that some businesses are more powerful or valuable as the number of users increases;
5) Efficient scale, which is not the same as economies of scale in the sense that that’s really a part of a cost advantage. Efficient scale is the idea that some companies benefit from participating in a smaller market. So there is not as much value in competitors coming in, because they know it would disrupt the ecosystem of the overall market.
On whether companies with large market shares automatically get a moat
Not necessarily, sometimes market share can be a positive indicator that a company has done a very good job of growing in the marketplace profitably, but it’s not necessarily a good indicator of that. For example, the auto companies globally have very large market shares. There are few players with large market shares, like GM and Ford, that do not have moats, because they are unable to really produce the kind of returns that we’re looking for.
On the other side, sometimes large market shares can be a positive, especially for a company with a cost advantage because if scale plays a factor, then having more scale can help improve that cost advantage.
