Q: What is an investment moat and how do I know what to do with it?
A: An investment moat refers to a company’s ability to maintain a competitive advantage, creating a barrier to competitors. Like the traditional moat, the name comes from one that surrounds a castle.
Speaking at the Morningstar Individual Investor Conference, Mathew Hodge, director of equity research with Morningstar Australasia said investors should care about whether a business has a moat because it underpins strong returns for a long period of time.
Hodge says: “If we say a business has a moat, in our opinion it’s got an above-average quality business. [Moats] represent material entry barriers and we also view them as a quality factor. We view moat rated businesses as superior.”
A moat is calculated if a company can generate return on invested capital that is greater than weighed average cost of capital for at least 10 years. For a wide moat stock it would be at least 20 years.
Morningstar has a framework of five considerations that categorise competitive advantage. These are intangible assets, switching costs, network effect, cost advantage, efficient scale.
Hodge says: “For each stock that we have a moat, it has to fit into at least one of these categories. A really strong company like Google would tick multiple boxes. For example, our banks tick multiple boxes, they have cost advantage plus a bit of switching cost.”
Intangible assets are things like brands, patents, leases and licenses. A wide moat example of this is funeral home operator, Invocare.
Morningstar says: “It has a strong reputation and relatively price insensitive customers. Funeral service customers generally don’t shop around.”
Switching costs is where it’s either too difficult or expensive to move from one product to another and the company usually has pricing power. A wide moat example of switching costs is medical device company, Cochlear.
Morningstar says: “Key clinics are exclusive with almost no brand switching. Once installed, customer switching costs are very high.”
Network effect happens when the value of a company’s service increases for both new and existing users as more people use the service. The ASX is an example of a wide moat network effect.
Morningstar says: “More buyers attracts more sellers which attracts more buyers. A virtuous circle that’s hard to break.”
Efficient scale is when a niche market is effectively served by one or a small group of companies. These are businesses such as airports or railroads.
Hodge says: “You can have a high quality business like Auckland Airport which is maybe only generating a high single-digit or low double-digit return on invested capital but because it is a monopoly asset we are confident it can do so for a long period of time, so we rate that as a wide moat.”
When calculating if a business has a moat, Hodge looks at the earnings before interest and tax divided by the invested capital (debt + equity), which is the financing of the business.
Hodge says: “In the very best cases, firms can reinvest at high rates to compound those earnings and returns. When you buy those and you hold them for a long period of time and they do a lot of the work for you.”