How to Use Economic Moats for Long-Term Investing Success

The Power of Economic Moats in Value Investing

The first rule of investing is “do not lose money”. This speaks to the need for investors to make sure that the compounding of their investments proceeds in one direction only – up. While this is hard to ensure given the daily market noise, over a period of time this can be achieved by ensuring that the business underlying the stock is strong, and remains strong in the future. The stock price tracks the business performance over the long term.

How do you make sure that the business remains strong in the future? You do this by looking for economic moats.

In this article, we will take a deeper look at the economic moats, and why they are critical for a value investor to identify. We will also consider the challenge of finding moats in small cap value stocks. And in a nod to academia, we will draw a parallel between economic moats and the Quality and Profitability factors in investing.

What Is an Economic Moat and Why Does It Matter?

The term “economic moat” was coined by Warren Buffett to describe a company’s durable competitive advantage. These competitive advantages (a company may have more than one) allow a company to build a moat around its business that allow them to sustain high returns on capital and fend off competition.

Consider an extreme form of moat and you will understand why a moat is so desirable.

Monopolies – monopolies are businesses with such a grip on their market that it is extremely difficult for a competitor to survive and new competitors to emerge. These monopolies have very deep moat. Some of them exist due to regulatory context, others may exist due to large barriers to entry or uncompetitive practices of the type Antitrust act was created to prevent (for example, predatory pricing, price fixing, cartels, minimum price for resale, etc)

The companies with economic moats that we are more likely to be looking at fall somewhere between commodity businesses and monopolies.

As you know I generally invest in small cap value stocks, and small cap value stocks rarely have wide moats. You can however find narrow or emerging moats that can create asymmetric opportunities.

The key to moat investing is recognizing businesses that can protect their profits over time. But how do we assess whether a company truly has a defensible moat?

Types of Economic Moats (and Their Relevance to Small-Cap Value Investing)

There are many aspects of a business that can give rise to a moat. We will take a look at some of the more common ones.

Brand Power – A strong brand creates a moat as customers typically stay loyal to the brands they like. This makes it less likely that the brand products will be substituted with a competitors if the company were to raise prices incrementally. There is only so much a company can push their brand power though – we have all switched to the store brand or private label products when our favorite brand products got too expensive.

Works for niche small-cap players but is rare outside of consumer goods. You will find this more often in large caps where the company has built up scale and scope.

Network Effects – Facebook grew based on network effects. So did other social media like LinkedIn, Whatsapp, etc. Hard to find in small caps, but sometimes seen in software or specialty platforms. One example today could be Faire that has built a marketplace for small businesses selling wholesale to small retailers.

Switching Costs – Some small firms dominate their niche by making it expensive or difficult for customers to switch providers. For example, most mobile phones in the US will lock you in 1 or 2 year contracts that are hard to break without incurring high breakup fees. Additionally, the phones may be locked to the network and it may take time and effort to get them to unlock to switch to a different mobile service provider. You would think that it is hard to trap consumers into a high switching cost relationship – that is why you see so many mobile phone companies dangling the bait of free phones.

This may not be a strong moat. Eventually competition will chip away at this with more tempting offers and every market participant will suffer the consequences by bleeding profits.

Cost Advantages – Essential for small manufacturers, logistics firms, and businesses that operate with a lower cost structure than competitors. Much of the cost advantages in smaller firms come from better processes, innovative systems, etc. You are also likely to see very strong moats built on cost advantages by large companies as they achieve significant economies of scale and scope.

Regulatory or Licensing Barriers – Can create moats in healthcare, financial services, or specialized industrial sectors. For example, a patent on a drug gives the company exclusive right to market and sell the drug for 20 years before they have to worry about competition. Other examples of regulatory moats are utilities that are generally given sole right to produce and sell energy in a specified geographic area.

When we discuss moats, we are generally talking about larger companies. While moats exist in small caps, they often require deeper research to uncover. The real test is their durability over time.

Economic Moats as Quality and Profitability Factors

One consequence of strong moat is that the businesses are able to charge higher prices and enjoy greater margins. It then follows that companies with strong moats exhibit attributes that are congruent with the Quality factor and Profitability factor.

But you can also approach this from the other end. Quality factor companies, i.e. companies with high ROIC and strong balance sheets often have an inherent moat. This may not always be true, but it is definitely a stronger possibility.

Similarly, Profitability factor companies, i.e. the companies with high and consistent operating margins indicate pricing power, which is another sign of a moat.

A quick way to find companies that may have strong economic moat is to review the top holdings of the Quality factor ETFs and Profitability factor ETFs. Some examples are QUAL, DUHP and VFQY. You could also look at Morningstar’s economic moat ratings.

Alternatively, you can add a filter for profitability and high ROIC to your favorite stock screens that you use to find value stocks. This will ensure you only see the stocks that meet your quality/profitability criteria in addition to your valuation filters.

Understanding quality and profitability is useful, but moats alone do not guarantee investment success. We must evaluate the price we pay. Which is why a moat with a great value is the combination that you want.

The Intersection of Economic Moats and Value Investing

You have seen how value investing combined with economic moats can not only increase your chances of a profitable investment, but also keep the investment profitable for a long time as the company keeps growing its market and shareholder value year after year. There are reasons why a mere economic moat is not enough.

Great businesses can still be bad investments if the price is too high. You will probably tread water for many years before the profits catch up to justify the valuation when you bought the stock. While one can argue that you can still be profitable long term, you will lose a lot of time for the profits to realize which is an opportunity cost.

Many moated stocks are overpriced due to popularity (e.g., large-cap compounders). For example, an oft repeated advice is to buy Dividend Aristocrats and hold them forever while reinvesting the dividends. Because this is a popular advice, many investors do precisely this, as a result these stocks seldom trade at an attractive valuation.

Small caps are a bit different – value stocks are easy to find while the moats are hard. This is why it makes sense to go for quality/profitability factors while screening for value. You may not find true moat yet, but many of these companies will grow up to build this moat that you seek.

When Moats Disappear: Identifying Weaknesses Early

You may have identified a great company with solid moat and inducted it in your core portfolio. You intend to hold these stocks forever. Bad idea.

Existence of a moat today is a strong predictor of a durable competitive advantage i the future, but it is not a guarantee.

Moats can evaporate over time for any number of reasons. There may be new competitive threats you may not have planned for. For example, new innovative technologies or a market disruption that makes these products unnecessary. What good is having a monopoly on the horse carriage transportation, when invention of a motor car completely destroys the horse carriage market. There could also be regulatory changes that shrink the moats.

The phone business in the US has seen all of these play out over the years. AT&T had a strong moat and it was a near monopoly. Then the regulations broke it up into baby bells. Then there was competition in form of MCI and Worldcom. Later, the mobile telephony has now completely disrupted the landline phones.

Moats can be squandered through bad acquisitions or excessive debt. Keep an eye on the critical signs that may indicate an eroding moat. For example, declining ROIC, pricing pressure, insider selling, etc.

Now that we’ve covered how to identify moats and their risks, let’s discuss how to integrate moats into a long-term investment strategy.

Building a Portfolio Around Economic Moats

Very likely your portfolio will be a mix of reasonably valued but high moat ideas and deep value plays that may have no moat at all. You can decide how to plit your portfolio between these two types of stocks. Here are a few ideas:

1. Make a 50/50 or 70/30 split, or something similar and stick to it. You can compartmentalize the portfolio in to high moat longer term stocks that may be core part of your portfolio. The satellite part of your portfolio includes deep value plays that are more tactical in nature – you keep these stocks only as long as necessary to realize the value – you are not after long-term holds for these stocks.
2. Recognizing that there are cycles of market valuation, you may over load on deep value plays when they are more available, and under allocated to them when they are no longer easy to find

Warren Buffett started out investing in deep value plays when his portfolio was smaller. Once the portfolio grew large, it was impossible to buy enough of deep value stocks, and he had to start buying wide moat stocks. Now, his portfolio is mostly wide moat stocks and very few deep values.

The Long-Term Payoff of Economic Moat Investing

Finding moats in small-cap value stocks is challenging, but it can be done. Rewards are well worth it. Alternatively, stick to deep value plays in a part of your small-cap portfolio, and fill up wide moat stocks in the other part of your portfolio, even if you have to choose mid or large cap stocks here. Quality and Profitability are good indicators of potential moat, and therefore ETFs targeting Quality and Profitability factors are great places to search for these stocks. When you find a good wide moat stock to own, monitor it over time for signs of erosion, and of course, hold it for long term so your gains compound over time.