Wide Moat Stock Investing

Finding companies with wide moats around their businesses and competitive advantages can lead to great long-term returns. Knowing what to look for and understanding that wide moats alone are not an investment panacea are important considerations.

Wide Moats Protect a Company’s Profits

A wide moat is essentially a type of unique competitive advantage a company has over its rivals in its industry. The concept of investing in these types of strong companies that have durable competitive advantages was popularized by Warren Buffett, CEO of Berkshire Hathaway and one of history’s best investors. At Berkshire Hathaway’s 1995 shareholder meeting, Buffett had this to say on the importance of identifying a moat when investing:

“The most important thing [is] trying to find a business with a wide and long-lasting moat around it … protecting a terrific economic castle with an honest lord in charge of the castle.” 

Because highly profitable or attractive businesses are under consistent attack from competition, a moat around the business helps protect profits. Competitive advantage may come from a number of different sources:

• High Switching Costs: If there are high switching costs, customers are less likely to switch to another competitive product or service.
• Low Cost Producer: A firm may be able to produce goods and services more cost effectively vs. the competition, thus making more profits on sales.
• Intagible Assets: Patents, superior technology, greater talent or an unmatched corporate culture are intagibles that can lead to a competitive advantage.
• Efficent Scale: Industries dominated by a small number of companies have the benefit of efficient scale.
• Network Effect: Firms that benefit from a network effect see the value of their service or product grow as the number of users increases. Those companies that have massive reach and scale are the types of companies that generate a wide moat.

Competitive advantages, such as the ones listed above, have the potential to increase a company’s profitability and overall market share since the value of a company is a reflection of its future profits discounted back into today’s dollars.

How Company Management Affects Their Moat

Companies with wide moats typically have above average profitability, and as a result, they face constant competition. So, companies with wide moats have to consistently make efforts to improve their moats. Researchers at Morningstar, a research company that has studied wide moat investing, have found that there are four ways a company’s management can impact and improve a moat.

1. Restructuring: Investing in profitable business lines and divesting less profitable businesses.
2. Consolidation: Gaining economies of scale through the acquisition of other businesses.
3. Paradigm Shift: Taking advantage of some major change in the business or industry.
4. Innovation: Developing new processes, technologies, patents and other factors that influence innovation.

The same researchers also found that companies with wide moats were often larger in size. While small and mid size firms could have moats, firms with competitive advantages were mostly larger market capitalization companies. Their data also showed that investing in wide moat stocks was more profitable over time than the broader stock market. Wide moat stocks generated superior returns and displayed fewer risks compared to major market indices. The research also found that when wide moat investing was combined with other proven factors like value and momentum, returns improved.

Now let’s take a look at how we may be able to find companies with wide moats using publicly available financial information.

How to Calculate if a Company has a Wide Moat

Companies with a competitive advantage may display certain patterns in their financial information. We extracted these criteria from the book Buffettology, which quantified Warren Buffett’s investing method as closely as possible. The authors studied the stocks Buffett purchased and the qualities those companies possessed.

The first is that earnings need to be very predictable, meaning earnings need to be consistently increasing over time (at minimum a decade of increasing earnings). This measure shows that the profits of the business are steadily increasing and can give us confidence in a company’s earnings power into the future. By looking at profits over a decade, you should also be able to see how the profits held up during economic downturns, and if a firm remains profitable during recessions.

Earning Year 0 < Earnings Year 1 < Earnings Year 2 < Earnings Year 3 … < Earnings Year 10

The next two measures indicate the level of profitability by comparing profits to equity and capital.

• Return on equity (ROE) measures net income over total equity. The higher the number the better.
• Return on total capital (ROTC) measures net income over total capital, and since capital includes debt, this measure takes into account a company’s use of debt in the overall capital structure.

Once ROE and ROTC are calculated, an investor can look back over time to see if returns are above average or increasing over a ten-year period. If a firm has ROE and ROTC that are well above the average of all other companies and has been consistently producing that level of profitability, an investor could presume there is some level of competitive advantage and wide moat around the business.

ROE Year 0 < ROE Year 1 < ROE Year 2 < ROE Year 3 … < ROE Year 10

ROTC Year 0 < ROTC Year 1 < ROTC Year 2 < ROTC Year 3 … < ROTC Year 10

Where Wide Moats Can Be Found Today

While wide moat investing can be powerful, it’s important to acknowledge the caveats.

The first is that some companies with a competitive advantage may not be profitable in the short run because they are aggressively reinvesting back into the business in order to build or protect their competitive advantage. Our examples of identifying wide moats quantitatively assume long term profitability.

The second is that because companies with wide moats are often times recognizable by investors, those companies tend to have premium valuations. As a result, companies that can’t defend their moats can see their share prices fall over time while the winners reap the rewards of higher valuations.

Still, wide moat companies can be excellent long-term investments. By clicking the link below, you’ll be brought to a list of stocks, adapted from a Warren Buffett-inspired model that looks for firms with consistent growth in earnings over time and consistently high returns on equity and returns on total capital. These are the ingredients to wide moat stock investing.

See the Wide Moat Stocks in Today’s Market

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