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Fortify Your Portfolio: The Power of Moat Investing for Long-Term Wealth

Moat investing is not a new approach, it’s been around for a long time. It’s use as an investing term is thanks to famed investor, Warren Buffett. The crux of Buffett’s investment decisions are around finding companies with moats.

One of Buffett’s earliest, public references to moats came in 1994. In the Berkshire Hathaway Annual Shareholder letter he wrote:

In business, I look for economic castles protected by unbreachable “moats.”

Warren Buffett Berkshire Hathaway Annual Shareholder Letter 1994

The acceleration of moat investing came in the early 2000’s. Specifically, it arrived with Morningstar analyst Pat Dorsey. Dorsey was the Director of Equity Research at Morningstar from 2000 to 2011. He was the person who built the equity research team at Morningstar. It was Dorsey that wove moat analysis into the fabric of Morningstar’s equity research team. Even though Dorsey has moved on, Morningstar euqity research is still driven by the search for economic moats.

What underlies moat investing?

Competitive advantages are how companies construct moats to protect their business. Competitive advantages can come in many forms. For the most part, competitive advantages stem from the following areas:

  • Network Effects – when the value of a product or service grows as the user base grows. Each extra customer increases the value of the product. Think social media and credit card networks.
  • Branding – one of the hardest moats to establish but one of the strongest when in place. This is also called mindshare ownership. Brands benefit from information advantage and social proof. Think established companies that you cannot live without and follow their releases with bated breath.
  • Economies of scale – companies that can produce goods at a lower cost than competitors are often able to sell at the same price as competitors and bank excess profits. Think big box retailers.
  • Switching Costs – switching costs lock in customers to unique ecosystems. Switching can involve expense and effort that are barriers to switching. Think technology network hardware or software infrastructure.
  • Counter Positioning – is where a new company or product is positioned in a way that incumbents do not compete in fear of damaging their current business. Think camera film companies when digital photography cam along.
  • Cornered resources – when a company has the upper hand with resources they gain power. Resource control can come from patents, licenses or access to physical resources. Think pharma or biotech.
  • Process Power – when a company is system driven that enables it to provide low-cost, quality products at a better price or more efficiently. This is something that is at the core of a business and deeply rooted. Often times manufacturing companies

Moat investing 101

There’s more than one way to find moat investments for your portfolio. You could do some deep thinking about businesses that have some of the above traits. That approach might be a little laborious and fleeting. It is important to keep in mind the presence of competitive advantages does not mean a moat exists. Further, a moat does not mean the company’s stock is a great investment.

For a competitive advantage to turn into a moat and a moat to create a great investment we need one thing – solid management. Effective management knows how to profit from the moat.

For you, the long-term investor, finding moat companies is meaningful. A well entrenched moat with sound management allows you to hold a company for the long-term. The whole point of moat investing is to find companies that you can hold for the long-term while your capital compounds.

Finding moat investments

The best approach to finding moat investments is looking for competitive advantages clues. Unfortunately, there is no line item on a company financial statement declaring a moat let alone it’s width or depth. Rather, company results leave clues that a moat may be present. 

Here is a short list of quantitative and qualitative clues that points to profiting from moats.

1 – Return on Invested Capital (ROIC)

Return on Invested Capital (ROIC) is a powerful and popular datapoint. It is also the most complicated data point I’ll discuss here. Understanding this point is important because it’s a big one for me. ROIC simplifies in some ways and complicates in others relative to ROA and ROE. The most important note on the difference between ROIC, ROA and ROE is that ROIC puts debt and equity financing on equal footing, which removes the boost that levered (companies that use debt to grow) companies might see in ROE. Have no fear, ROIC is more often than not easily found by investment research providers like Morningstar. So, you will not have to calculate it but, you should understand what it means.

Generally speaking, I look for ROIC consistently above 15%. In reality, I look to compare ROIC to the market as a whole and to other companies in the same industry and sector. The higher and more consistent the better and more likely there is a moat or growing moat happening.

2 – Free Cash Flow

Keep in mind, that some metrics are not meaningful for some industries. What follows are key items we compare across companies in the same industry to find the cream of the crop. Before I get into some of the other metrics, I want to spend a minute on one very important metric – Free Cash Flow (FcF). 

FcF is the cash generated by a business that is available for distribution among its stakeholders which includes equity, debt, preferred stock, and convertible security holders. FcF is used to:

  • Pay dividends
  • Make acquisitions
  • Research & Development
  • Invest in new plants and/or equipment
  • Pay interest expenses
  • Reduce debt 

In my opinion, free cash flow is the best indication of a company’s ability to generate cash. The higher and more consistent a company generates free cash flow the better. We’re not going into the weeds with the formula. But, very simply free cash flow is the money left after covering all the costs of doing business. That’s why it’s called free cash flow; the business is free to do as it wishes with the money.

3 – Cash Return

Cash return shows how much FcF a company is generating as a percentage of enterprise value. Enterprise value (EV) is a very common term to find for a company.  Simply, it’s the total value of the business. EV measures what the market believes the company is worth and is the total value of the business including equity and debt. EV is considered to be the takeover price of a business. This is due to the fact that the purchaser will take on the debts, keep the cash and have a right to all earnings down the road.

I want to see cash returns above the 10-year US Treasury yield. You can find the 10-year yield with a quick search on the internet. Do not use cash return to evaluate financial companies or other companies that earn money from assets on their balance sheet – i.e. banks, insurance companies etc. Honestly, I have never had interest in investing in banks or insurance companies.

4 – Net Margin

Net margin is net income as a percentage of sales (revenue). Very simply, it tells us how much profit the company generates per dollar in sales. The higher the better, period. At this point you are getting the picture that net income is an important number for many ratios. 

Generally speaking, I look for net margins consistently above 15%. In reality, we look to compare companies to other companies in the same industry and sector.

5 – Brand as a verb

The name of this one alone tells you that we are departing from the quantitative part of finding moat stocks to the qualitative side. The reality is, moat’s are more often derived from qualitative aspects. The quantitative data points are the evidence of the economic moat’s impact. 

One of the most obvious clues that a company may have carved a moat is when the company, product or service becomes a verb. At the point of verb utilization, there is entrenchment in a massive amount of psyche. A few examples in (2023) are Google, Uber, Photoshop, Instagram, Venmo, and many more.

6 – Not commoditized

This is a departure from the rest of the hints in that it refers to what a company is not.More often than not, commoditized items or businesses have a hard time establishing a moat or maintaining a moat. But, what do I mean by commoditized business or products. Commoditized, in this sense, means that a product is deemed the same across the board. Simply put, the items become indistinguishable across competitors.

Some prime examples of commoditized businesses are airlines, trucking companies, railroads, utilities, and phone carriers. To be sure, some businesses within the above mentioned industries have found ways to carve out moats. For example, well run trucking companies that play in a particular area like less-than-a-truckload could have a moat.

As you think through a company, question if the business or service is commoditized to the point where pricing is impaired because other companies do the same thing at a same price.  If so, move on to your next idea.

Summary

Moat investing is a sensible way for long-term investors to invest in best of breed companies that can generate profits for many years. A moat-oriented investing strategy will reduce your amount of research. The less time you have to spend researching is the more time you have for capital compounding.

If you are a long-term investor, our next post will outline why It’s time to start driving your portfolio and know what you own.

This website and associated newsletter along with its content/links are not financial advice. Nothing in this newsletter is an investment recommendation. All content is created for entertainment, educational, or informational purposes only. My strong buy, accumulate, hold, reduce or sell opinions are exactly that – opinions. Be sure to do your own research for your own particular circumstances or higher a professional advisor.

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