This week we’re going to explore the topic of moats. No this is not yet another weird acronym, though you do sometimes see it written all in upper case so if you’ve been confused by this you’re completely forgiven. The idea of a business moat is the same concept as a moat around a medieval castle. It is about protection and long-term survival. It’s not hard to see how these characteristics might be attractive in an investment. So in this week’s post we’ll explore where this moat concept came from, look at some examples, and then consider how you might apply it on your journey to gaining choice.
I need to mention that I do talk about specific stocks and ETF’s as examples in this piece. This should in no way be considered a recommendation, I know nothing about your circumstances, and so have no idea what the right investment is for you. If you are after one on one financial planning advice, check out the advice page for the details of how we might be able to help.
To discuss the idea of moats in the investment universe, it’s important to first understand the idea of value investing, as the two are very much linked. The grandfather of value investing was an American called Ben Graham who wrote The Intelligent Investor in 1949, a book Warren Buffett described as the best book ever written about investing. In it he advocated long term investing, truly viewing yourself as a part owner in the business that you are investing in and participating in their journey. His strategy was all about looking for businesses that were selling below their true value.
Warren Buffett was so impressed by Graham’s ideas he specifically chose to study at the university where Graham lectured when he finished high school. They struck up a lifelong friendship and Graham is considered Buffett’s key mentor.
Buffett is today’s value investing poster child (if you can in anyway refer to someone in their 90’s as a child), though he acknowledges that his approach has evolved from some of Graham’s original teachings. The combined success of Graham and Buffett has led to many disciples of the value investing approach.
It is within this value investing sphere that the concept of moats arose. Though he didn’t invent the idea, Buffett mentioned it in one of his annual shareholder updates, and that lead to the popularisation the concept.
A moat in the investing context is defined as:
a business’ ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share from competing firms
A competitive advantage is an advantage one business has over another. It could be access to cheap natural resources, low cost workers, or highly skilled researchers. The thing with competitive advantages though is that usually they evaporate overtime. As the business succeeds and grows, competitors take notice and, if they can, change their operations to replicate this new found efficiency. Where competitors are unable to respond, new entrants typically arrive and again mimic whatever the advantage was, gradually reducing the abnormal profits overtime.
The core in this definition of a moat is in thinking about businesses who have a competitive advantage which is sustainable for a long period of time. It’s not hard to see why, as an investor, such businesses might be attractive.
Disney could be considered a business with a moat. Through its ownership of Star Wars, PIXAR, and Marvel, it has an unparalleled catalogue of fictional characters from which to develop entertainment products, something any new entrant to the space would find impossible to match.
Uber’s moat is the power of networks. It has the drivers and it has the users with the app on their phone. For a new entrant to come in, it’s very tough to compete – drivers don’t want to sign up because there aren’t enough passengers, and passengers don’t join because they’re aren’t as many cars on the road as Uber can offer.
Patagonia has built a moat around culture and positioning, All fashion has a “what this says about me” element to it, and consumers sporting the Patagonia brand are keen to show an appreciation for the natural world.
Local examples of long term sustainable moats might include Cochlear, whose technological lead in hearing implants provides a significant barrier to competition. ASX, whose effective monopoly on the secondary market for listed shares here in Australia makes it highly resistant to competition. Or Transurban, with its network of toll roads in our capital cities, near impossible to replicate.
Application of a moat approach
Okay, so a moat is a competitive advantage that is sustainable over the long term. Does that mean we should be looking to invest in every business that appears to have a moat? No.
As I covered at the beginning of this piece, the moat concept falls within the value investing universe. It’s application to portfolio construction occurs when a value investor combines the idea of a moat with the idea of determining stock price valuations based on fundamental analysis. The goal is to not just find businesses that have moats, but undervalued businesses that have moats.
Interestingly, as intuitive as it sounds to construct share portfolios around this value based approach of undervalued businesses who possess a moat, performance data shows that investor outcomes using these strategies have lagged other approaches. Over the past few decades, more successful approaches have been either the index type approach where portfolios are constructed mechanically based on the size of the business within their market, or a growth approach where stocks are selected with a focus on their potential to grow income and profit.
Moat’s day in the sun?
Some commentators wonder however whether the value approach might be about to have its day in the sun once more. Certainly, value strategies performed well as markets rebounded from the COVID induced drop in 2020. The market’s greatest concern at present is the potential for a rise in inflation, something we haven’t experienced for a very long time. In that environment, the argument goes that businesses that could perhaps be considered boring, but which produce consistent profits, could be the new market darlings. Consider Transurban that I mentioned earlier had a strong moat due to its one-off infrastructure. If we had a spike in inflation which saw prices and wages rise, Transurban would have no difficulty passing that on to consumers via increased tolls. In fact, it’s almost certain that their government contracts would have it built in that they can adjust for inflation. Consumers have little choice but to use their roads if they want to get around their capital city efficiently, and so shareholders in a business like Transurban are well-protected in an inflationary environment, perhaps making this an attractive investment.
So how could you use the concept of moats in your wealth creation strategy? Well, if you go down the individual stock route, some researches will provide a moat rating for individual companies. Morningstar for instance includes this, and I’m sure plenty of others do too. Now as with all research this is simply their assessment, so you need to reflect on whether you agree with that assessment. But it may be useful start.
You could look at actively managed funds that apply a value approach. The likes of Perpetual, Maple Brown Abbott, and Investors Mutual are classic Australian value investors.
And then there are newer ETF solutions that apply a value based approach. Typically they will start with their traditional market weighted index, and then tilt the portfolio based on certain factors around quality. VanEck for instance has an ETF called MOAT that certainly nails its colours to the mast. Betashares has a QOZ which also embraces a value approach.
All businesses have some sort of competitive advantage, otherwise they wouldn’t have survived. And if a business has grown and survived long enough to get listed on a share market, the advantage has proved lasting. The moat idea is to reflect on how that advantage is likely to fare into the future. Will it persist or will competitors catch up and perhaps even overtake it? If you conclude that the advantage will persist, the next question is whether the price that you can currently buy that stock for is attractive.
Hope this helps you on your journey.Back to All News