Adding economic moats to your stock analysis can help you to develop and be confident in your investment thesis, i.e., why a stock is a good pick for your portfolio. A company’s economic moat can also shed light on loser stocks you have and don’t know what to do with.
A moat is a ditch, either dry or filled with water, surrounding a castle or town, that acts as a primary line of defense. Historically, moats were used to protect our most precious asset: where we live.
The term economic moat refers to the factors that help a company survive and thrive, and how long these factors will exist. In other words, what keeps the castle standing and for how long. Is the castle protected by a moat and structures that are wide and built to last, or is it without a moat, still standing only because the lord of the castle is a genius that no one wants to or can take down for now?
Let’s dig in.
Protection offered by economic moats
An economic moat is a lasting competitive advantage that makes a company better than the others. A wide and durable economic moat helps a company ward off competition and makes it easier for it to generate above-average returns for years.
What constitutes an economic moat for one company or industry differs from another. Morningstar identifies different types of protection that constitute economic moats:
- Switching costs that make it too difficult or costly for customers to switch from one supplier to another. A company enjoying this type of protection is said to have a sticky business model.
- A network effect that makes a product or service more valuable and appealing as more people use it. It’s a snowball effect; as more people buy the product, the company improves it, making existing customers happier and drawing in new customers. Rinse and repeat.
- Intangible assets include patents, trademarks, brand recognition, and proprietary technology.
- Cost advantages refer to the ability to produce goods or services more cheaply than the competition. Just think about Amazon or Walmart.
- Efficient scale means that the market where a company operates limits the number of competitors, for example, regulated utilities that are granted a monopoly over a region.
A company can have more than one of these types of protection in its armor. Stay tuned. Articles in the next few weeks will explore these types of economic moats in detail.
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How long will the moat last?
Another aspect of economic moats is how long they will last. Some advantages could quickly evaporate while others may remain for a long period. Patents expire, someone can develop better proprietary technology, and governments can step in to open up competition in monopoly or oligopoly situations. Morningstar classifies moat life expectancy as follows:
Wide moat (20+ years)
A wide moat is one or more long-lasting competitive advantages, expected to be effective for 20 years or more. For example, railway companies aren’t likely to see competitors build an alternative railroad alongside theirs overnight, if ever.
Narrow moat (10 years)
Narrow moats are competitive advantages that exist today, but that might not continue in the future. Interpretation could come into play; for example, Morningstar gives a “narrow moat” rating to Enbridge, despite its contracts being usually for over 20 years. Morningstar says “We are far more uncertain around long-term demand in the latter stages of our forecast due to the high carbon emissions intensity associated with the full cycle of oil sands production, which is a primary source for Enbridge’s assets”.
No moat
Companies with no clear competitive advantage, or with some that will quickly dissipate, have no moat.
Impact of moat duration
Why is the moat’s life expectancy important in your analysis? Because it determines how much time you have to generate profit from your investment. When you invest in a company with a wide moat, you have a longer horizon to make money since the business will benefit from competitive advantages for a long time.
In contrast, a company that has no moat, such as Peloton, has little time to generate a maximum profit before competitors see the opportunity and enter the market. Since there’s no protection, the castle can easily be taken by force.
Next week, we dive into the types of moats, or competitive advantages, in more detail.
Are companies with economic moats good investments?
Not necessarily. Some companies don’t have long-lasting moats or none at all, but are still amazing. Some companies show a wide moat yet end up reporting terrible results. Here are a few examples:
- AT&T (T) has a narrow moat according to Morningstar but has shown terrible returns over the past 10 years (32% total return).
- Equinix (EQIX) has a narrow moat rating but generated 485% in total return during the same period.
- Great-West Lifeco (GWO.TO) has no moat and generated a 121% total return.
A company’s moat is just one of the things to consider.
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Finding information about company moats
Here are some resources where you can read about companies’ economic moats:
- Investment websites and blogs: Sites like this one! Also, the investment thesis on the Dividend Stocks Rock stock cards mentions the competitive advantages of companies. Morningstar, Seeking Alpha, and Investopedia publish articles and analyses discussing companies’ economic moats.
- Financial news outlets: Bloomberg, CNBC, and the Wall Street Journal frequently cover companies’ competitive advantages and economic moats.
- Company reports and filings: Companies often discuss their competitive advantages and strategies in annual reports, investor presentations, and regulatory filings.
- Industry reports and analyst notes: Research reports from investment banks, equity research firms, and independent analysts.
- Business and finance magazines articles including those of Forbes, Fortune, and the Economist
Takeaway
After reading several economic moat ratings by Morningstar, I can’t say that I always agree with their analysis. Since the goal is to assess what could happen in the future, your interpretation of a company’s moat might differ from Morningstar’s or mine. Beauty is in the eye of the beholder.
That said, I like the concept of economic moats. It helps define a strong investment thesis and helps investors figure out if the dividend triangle will continue to grow based on the company’s competitive advantages. If you can’t find those advantages, those moats, the company is probably riding a short-term hype.
Thriving businesses have many things in common, including a strong dividend triangle along with a set of moats protecting the business. Next time you review a company’s dividend triangle, ask yourself if the business has a strong economic moat that will enable it to sustain its dividend triangle trend.
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