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How wide is your moat?

How wide is your moat?
September 17, 2014
How wide is your moat?

But investors also face the risk of over-compensating by buying stakes in companies with poor prospects. All cheap stocks are cheap for a reason. Value investors face the difficult task of identifying those that are cheap for a reason that will prove ephemeral.

One way of doing that is to focus on the 'quality' of the company: the consistency and longevity of its profits. Quality is often overlooked by City analysts because it is hard to number-crunch. But one research house, Morningstar, has developed a useful theoretical framework to assess it. Inspired by Warren Buffett - who once said he looked for "economic castles protected by unbreachable moats" - it revolves around the medieval metaphor of the moat.

The basic insight is that competition may be good for consumers, but it is bad for investors. The closer a marketplace resembles the economist's dream of 'perfect competition' - innumerable small companies providing identical products or services - the less attractive it becomes. In order to generate sustainable profits, companies need protection from competitive attack.

That protection, or 'moat', can take five forms, according to Morningstar's analysis. First, intangible assets, which include brands, patents and regulatory licenses. Brands famously increase a customer's willingness to pay, but Alex Morozov, Morningstar's director of research for Europe, Middle East and Africa, stresses that only the best brands give companies sustainable pricing power: "Burberry (BRBY) has it; Abercrombie & Fitch (US: ANF) probably doesn't."

Patents are particularly relevant in the healthcare and technology sectors, conferring on the holder monopoly pricing power for a limited period. Government licenses were more important historically - think of the East India Company - but regulation can have much the same effect. The UK government riles against banks that are too big to fail, and claims to want to promote competition, but its own regulation effectively excludes all but the best-funded new entrants. The same goes for the privatised utilities.

Morningstar's second source of moats is switching costs: companies can exploit consumers' reluctance to change provider. The simplest model here is the razor company that sells razor blades as expensively as it can without causing the consumer to buy a whole new razor, but software groups are more common examples. "It takes time and effort to retrain everyone, so that the cost of upheaval exceeds the benefit of changing platform," says Mr Morozov.

Third, there may be 'network effects' that make a service more valuable the more customers it attracts. Alibaba is the most topical example, but a more familiar one might be Rightmove (RMV). The more estate agents who pay for the website, the more useful it is to house-hunters; and the more house-hunters use it, the less estate agents can afford to ditch it. Such companies become successful somewhat by chance, benefiting from a virtuous circle of popularity that is extremely hard either to anticipate in advance or to replicate afterwards.

Fourth, companies may enjoy a cost advantage that rivals cannot reproduce. This advantage may lie in an irreplaceable production process, a superior location (a former finance director of Go-Ahead (GOG) once told me the profitability of London bus companies all depended on the location of bus garages), in scale that takes time to amass, or in access to a unique asset (Elementis (ELM), for example, owns a mine in California that is the world's only known source of hectorite clay - a crucial raw material in some of its flow-enhancing additives).

The final moat is perhaps the least obvious: what Morningstar calls "efficient scale". This refers to a niche market in which a few incumbents make healthy profits - but not so healthy as to attract new entrants. "The market is too small to interest the competition," explains Mr Morozov, citing regional airports or the Canadian National Railway (Ca: CNR). A somewhat different example favoured by my colleague Philip Ryland is WD-40, as our recent feature on the World's Best Company explained.

Moats alone do not make a high-quality company: the castle also needs to be strong. British American Tobacco (BATS) has legendary pricing power - a combination of brand, cost advantage and efficient scale, perhaps - but in a declining market. Thinking about moats in this structured way is, however, a useful stock-picking discipline that can help investors avoid chasing cheap ratings. Run through the companies in your portfolio. What kinds of moat surround them? And just how wide are those moats?