The idea of an ‘economic moat’ was by most accounts first articulated by Warren Buffet. As with a physical moat around a castle, moats when applied to investment are about setting up a defence.
Given the increasing list of worries in the global economy and the rising calls for adding defensive elements to portfolios, realigning equities holdings to place a higher weighting on companies with protective moats could be the order of the day.
An economic moat is a simply a barrier which reduces or eliminates the effect that negative external events and outside forces can have on a company’s revenues and profitability.
According to Morningstar co-CEO Heather Brilliant there are five principle sources of moats which can be enjoyed by companies. There are intangible assets such as brands, patents and regulatory licences, switching costs which mean customers are unwilling to move their business to competitors, or there can be what she calls a network effect, meaning the value of a good or service grows as more people use it.
Then there is cost advantage, whereby a company can get its inputs cheaper than competitors can access similar things, and finally a moat can be based on efficient scale when a company operates in market which is too small to make it financially worthwhile setting up a competing business.
Brilliant said she considers moats also fit into two even broader classifications of narrow, meaning one which offers a company protection for at least the next ten years, and wide, whereby the period is at least 20 years.
Should one or more of the geopolitical or macro flashpoints cause a significant shock or downturn in particular markets, the theory is that investors who have a higher proportion of moat owning companies will see much better preservation of valuations in their equities holding than those who do not.
Those looking for moat candidates may be best served by choosing their sectors wisely however. According to Brilliant and her team, the utilities, technology, commercial service and healthcare sectors offer the best prospects for identifying companies with moats.
On the other side of the coin the basic materials and consumer cyclical sectors have the fewest companies benefiting from moats.
If you are a wealth manager with a bearish outlook, it may be time to pull out a spade and start digging.
