Hardbound

The moat effect

Simto Investment Company's chief investment officer Rajesh Bhatia reviews Why Moats Matter

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Published 9 years ago on May 15, 2015 3 minutes Read

Did you know that $1 invested in a US tobacco share in 1900 would be worth $6.3 million (with dividends reinvested) by 2015? This translates to about a 15% compounded rate of return over the 115-year period. This example offers two insights for investors: one, the magic of compounding and two, the merits of identifying a great business — one that can fend off competition and earn and sustain high returns on capital for a long period of time.

Just as a moat protect castles against enemy attack, economic moats — a term coined and popularised by Warren Buffett — are sustainable competitive advantages a business possesses that prevent competitors from attacking its ability to earn profits in excess of its cost of capital. Morningstar, a global investment research firm, has made the concept of moat investing the cornerstone of its approach to stock investing.

For corporate executives or investors with a limited understanding of the concept, Why Moats Matter: The Morningstar Approach to Stock Investing is a good place to start. Authored by Heather Brilliant and Elizabeth Collins, the book is divided into two parts — the first outlines the conceptual framework of moats and how Morningstar uses it to approach equity investing and the second, aids readers in independently researching and applying the concept on a sector by sector basis.

Morningstar identifies five sources of an economic moat — cost advantage, intangible assets, switching costs, efficient scale and network effect and cites several real-world examples. It mentions the Apple iOS platform’s ability to sync media across all Apple devices, discouraging users from switching to other platforms and allowing the firm greater pricing power.

The book acknowledges that sustaining advantages for long periods is rare by assigning a wide moat rating (a company likely to earn excess return for at least 20 years or more) to only 200 companies globally.

Noting that economic moats are never stable due to continuous competitive action, it assigns a positive rating to a firm building on its competitive advantage and vice versa. It offers the examples of Nokia and Palm, whose moats eroded owing to new products and changes in technology. 

Acknowledging that while strong management itself cannot form the basis of an economic moat (since management is subject to change), management’s skill in capital allocation is critical and can lead to significant enhancement or erosion of a moat. 

Disappointingly, the authors have only considered a decade’s worth of data to compare the performance of wide-moat stocks relative to others, meekly concluding the obvious — that price relative to intrinsic value is equally important. Back testing data for a longer period would have offered a variety of insights and heightened the appeal of this concept. 

To conclude, Why Moats Matter deals with a central concept in investing. Deeply ingraining this concept as a part of one’s investment framework by reading (and re-reading) on its applicability makes the book a worthwhile pick.