The importance of an economic moat is emphasized nowadays by almost every investment authority. A big deal is also made about it in the analysis of Morningstar investment services.
I’m sure they’ll be quick to show you how much better companies with a “wide moat rating” have performed in the past. You’d better though not to confuse cause and effect here: A company that’s successfully increasing earnings and revenues will easily earn a “wide moat rating” whereas a struggling business will be recognized as “no moat firm.” Now that is pretty silly as the whole thing turns out to be a self fulfilling prophecy. To make matters even worse Morningstar analysts are quick to change the moat ratings as soon as results worsen. So be prepared for a lower number of wide moat companies in the next months!
Now what does Ben Graham think of the nature of business? I think a good illustration lies in this quote:”Many will rise up that have recently fallen and those that are having a high reputation will fall down from their prestigious status. Mr. Buffett as well realizes the difficulties when purchasing companies that rely heavily on intangible assets:”What I perceived as a durable economic moat diminished quickly.” The core question can be formulated as follows: Is it possible to achieve superior results when purchasing well established companies with a proven record and what can be perceived as a wide economic moat?
Let’s pick 10 companies from the Dow with exactly that: A proven record and a big moat. The list looks as follows (10yr timeframe, dividends have been reinvested):
|Company||Annual RoI||11yr EPS growth:||10yr Rev. growth:|
Now this is a very disappointing return for an investor. In the same time the Russel3000 index advanced 3.8% and the Russel2500 index (shutting out the 500 biggest US companies) advanced 9% annually. Obviously the spectator now finds it hard to realize the merits of an economic moat. A possible defense could be that in 1999 these companies simply have been so much overvalued that results consequently had to be disappointing. There’s some truth in this as the earnings appreciated in a much more comforting manner than stock prices, as can be seen above. However one should also realize that the revenue growth has been considerably lower. In the long run earnings can not grow faster than revenues (remember Achilles race with the turtle). This bitter truth is going to overhaul many corporate managers soon. As we can conclude investing is not as straightforward as Morningstar suggests. I just stare at the composition of the Dow back in 1928 (the first time it carried 30 companies). Exactly 2 companies are still on today’s composition - GE and GM (a few changed their name and owners though). The latter one however will sooner or later probably cease to exist. This clearly shows the destructive force of capitalism. Even the bluest blue chip companies can not grow forever. The reason is obvious: Once an entity becomes extremely big there’s no more untouched ground to grow on and even if - it is minor in relation to the business that’s already exercised. Additionally there are many practical obstacles in the way – e.g. the flow of information gets slow and the company becomes unmanageable. The average lifetime of a Fortune 500 company is well below 50 years. So when these companies earn their place after 25 years and some in this prestigious list their lifetime is already longing for an end.
Maybe this article will stimulate investors to revise their view on the nature of blue chip companies with a proven record and a wide economic moat. To answer the core question posted above in the text: The investor can only expect to achieve superior results if he buys a business well below its intrinsic value. Only a wide margin of safety will ultimately provide safety of principal and an adequate return. A wide moat is no substitute for the former. However estimating future cash flows for a good business with an economic moat is arguably much easier than for a modest business, hence it is easier to figure out the intrinsic value. So in the end it’s all Ben Graham again – long dead his mindset is still far ahead of most (if not all) of us and we can be grateful to sit under the trees he planted a long time ago.