Diving Into Economic Moats

Diving Into Economic Moats

By Jeremy Glaser and Heather Brilliant, CFA | 07-10-2013 02:00 PM

Jeremy Glaser: For Morningstar, I’m Jeremy Glaser. We’ve recently launched a dedicated economic moat section in our Premium Stock Analyst Reports. I’m here with Heather Brilliant, the global director of equity research, to talk about the importance of economic moats and the best way to use this new section. Heather, thanks for joining me.

Heather Brilliant: Thanks for having me, Jeremy.

Glaser: So let’s talk a little bit about what an economic moat is. I know it’s a term we talk about a lot. But what exactly does it mean? How should investors be thinking about it?

Brilliant: So, we use the term “economic moat” to connote a sustainable competitive advantage. And importantly, an economic moat rating has been available as part of the Premium service for a long time, and what we’re really doing now is trying to give investors a little bit more insight into how we arrive at that economic moat rating, or why we think a company has a moat or not. And so, when you read the section, you can really get a deeper sense of, well, why is this company a wide moat or a narrow moat, or even, why doesn’t it have a moat? And so, I think that will really enhance the direct applicability of some of the research to the ratings that we’ve been putting out for some time.Glaser: So what are some of the structural advantages that a company can have that will give it an economic moat?

Brilliant: Well, there are really five main ways we’ve identified a company can carve out an economic moat within its industry. And the first would be a cost advantage. So cost advantage is really just the idea that sometimes a company can actually produce something or have a process that results in better efficiency, and produce something at a cheaper cost than its competitors.

The second would be intangible assets, and this refers to brands or patents that compel a consumer to pay more. Tiffany is kind of the quintessential example of this, since they sell a commodity item that is literally worth more simply because of the brand.

The third would be switching costs. And switching costs is really focused on the concept that sometimes it’s more costly to switch to another provider. Even if that other provider might be offering something that could be perceived as better or cheaper, the customer doesn’t always want to switch to it, because the cost of switching is so great. Banking is actually one of these examples, where you see a lot of individuals not switching from one bank to another, even if their fees go up, even if they experience some difficulty, because the cost of switching is just so irritating.

The fourth source of competitive advantage is the network effect. And here we are looking for companies that really see the value of their business increase as the number of users increase. So we talk about Facebook as a timely example, I guess you could say, of this [type of moat], particularly because Facebook has one of the largest networks we’ve ever seen developed anywhere, with more than 1 billion users globally. Now, they are still in the process of figuring out how to monetize this to its fullest, but we believe that network is extremely powerful and will result in opportunities to monetize it.

The final type of competitive advantage is called efficient scale. And here we are looking for markets that really aren’t large enough to support another competitor. So, it’s very distinct from economies of scale, which is really part of a cost advantage. Efficient scale is the idea that some companies are operating in a market that another competitor could not effectively compete in and make a profit.

So, I talk a lot about the New Zealand market when we’re referring to efficient scale. And that’s really because in New Zealand, the market is very small and very remote, and there are a lot of companies there that make excess returns. But if another company were to enter into a variety of industries within New Zealand, then neither the existing player nor the new entrant would earn excess returns. So that knowledge, and the research of that, really keep competitors out.

Glaser: So, why should investors care about moats, then? Does it make sense to only invest in wide moats? How do you think about it from an investing standpoint? How important is the moat to that analysis?

Brilliant: Well, at the most fundamental level, we believe that companies with moats are worth more than companies without. So because of their ability to compound returns over time, and to sustainably reinvest in businesses or in their core business, that earns excess returns going forward, both of those factors make up a business that is … worth more than a comparable business that doesn’t have a moat or that is not earning those excess returns.

The other thing I would say is we’ve done a lot of research around moats over the years, and one thing we found is that moats can really reduce the risk in your portfolio as well. So, we have found that a company that has a wide moat is much less likely to go bankrupt than a company with no moat, and also much less likely to cut its dividend, and so those are really powerful ways to reduce the risk in your portfolio.

How does valuation play into this? Is it worth paying up for these wide-moat stocks, maybe paying a little bit higher valuation for the better business quality?

Brilliant: We still think it make sense to buy any stock when it’s trading at a discount to that fundamental valuation, but there are two ways that we do think we end up requiring less of a discount for a wide-moat company. The first is that the cash flows are generally easier to forecast and it’s easier to understand how they earn excess returns. So, because of that, our wide moat companies typically have lower uncertainty ratings than our no-moat companies.

The second is that, we believe that wide-moat businesses can compound excess returns for longer periods into the future, and so we do literally see a higher valuation because of that. You see them earning excess returns in our model for a longer period of time than you would for a business that doesn’t have a moat. And so, inherently, a wide-moat businesses is worth more, which ends up being relatively equivalent to the idea that you would be willing to pay up for it.

All that being said, though, we would definitely recommend waiting for a discount to fair value whenever possible, including with wide moats. And I stress that because we’ve looked over time at the performance of wide moats versus the performance of wide moats trading at a discount, and if you just buy wide moats, you’d generally perform relatively in line with the market. But if you buy wide moats at a discount, we have seen extremely strong outperformance that seems very persistent over long periods of time, particularly over the last 10-plus years.

Glaser: What do you do in an environment where there might not be any wide moat stocks that are trading at a big discount? Does that mean you have to sit on your hands and wait for the market to fall?

Brilliant: Well, it really does depend on the investor, and there are a few different ways that I would handle that. I would say first that a lot of investors are willing to pay up a little bit more for a company with a moat. We still don’t think you should pay above fair value, but anything below fair value gives you a cushion, and so, since those wide-moat businesses can compound excess returns, you should still do pretty well.

And I think MasterCard is a good example of this. MasterCard is trading at a premium to our fair value right now, but it still does return somewhere in the neighborhood of 10%, 15%, 20% a year, because it’s so good at reinvesting in this business, basically being a toll operator within the financial-services industry. So, that’s a business that we’d love to own if it were trading at even a small discount. That would be one I would say to put on your radar and be willing to buy at even a small discount to fair value.

Glaser: Heather, thanks for the updates today.

Brilliant: Thanks for having me, Jeremy.

Glaser: For Morningstar, I’m Jeremy Glaser.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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