Christine St Anne: Moats have been traditionally associated with castles. But as an investment concept, it was first pioneered by Warren Buffett. Well, Morningstar has just launched a book, all about moats, and today I am joined by the co-author of the book and CEO of Australian business, Heather Brilliant.
Heather, welcome.
Heather Brilliant: Thanks for having me.
St Anne: Heather, first of all, what is a moat and why do moats matter?
Brilliant: So a moat is a sustainable competitive advantage and really we’re 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.
St Anne: So Heather, what key measures are used to determine whether a company has a moat?
Brilliant: 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.
We look for the presence of intangible assets, that allow a company to either charge more than competitors or differentiate themselves in some way; we look for switching costs; and third, we look for a cost advantage or an ability to produce a good or service at a lower cost than competitors; fourth, we look for a network effect, which is really the idea that some businesses are more powerful or valuable as the number of users increases; and fifth, we’re looking for what we call 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.
St Anne: Heather, your major concepts like intangible assets and the network effect, which are normally associated with companies with large market shares. So do those companies automatically just get a moat?
Brilliant: 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 is few players with large market shares, companies like GM and Ford, do not have moats, even though they have very large market shares because they are unable to really produce those, 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.
St Anne: So, Heather, in this sort of market, are investors better placed to invest in an expensive moat business or look at a lower quality, but better priced company?
Brilliant: Well, 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.
St Anne: Finally, Heather, can you give us any insights into what sort of moat companies are out there globally and closer to home in Australia?
Brilliant: Sure. Actually, I think the banking industry in Australia is a really interesting example because, globally, we find very few banks with wide moats. Generally, they have narrow or sometimes even no moat, because it’s a very competitive landscape. But in Australia, the market is really dominated by the big four banks and so, because of that, they end up having a kind of a rational oligopoly, that allows all four banks to earn excess returns. So we consider all four of the Australian banks to have wide moats.
Another interesting example is actually in the grocery space, where on a global basis, grocers do not have any moat at all. It’s a very competitive business once again. But in Australia, you have a rational duopoly between Wesfarmers and Woolworths, and because of that both companies actually have a wide moat. They benefit from a little bit of a network effect because they have stores in all the locations that most consumers would be interested in shopping and they also benefit from a cost advantage, because they have more scale than any of their competitors could gain.
St Anne: Heather, thank you so much for your insights and all the best with the book.
Brilliant: Thanks very much, Christine.
This article orginally appeared on Morningstar.com.au
