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Rupert Hargreaves
Rupert Hargreaves
Articles (1229)  | Author's Website |

Does a Business Moat Mean Outperformance? The Answer May Surprise You

A study looks at moats and outperformance

January 22, 2019 | About:

Whenever he’s considering an investment idea, Warren Buffett (Trades, Portfolio) is always looking to understand the company’s moat. He wants to know if the company has a competitive advantage, what it is and what management is doing to protect it.

Buffett is one of the wealthiest men in the world and widely recognized as the world’s best investor, so his moat strategy clearly has some substance. The question is, can it be replicated by the rest of us?

Replicating Buffett's strategy

As Buffett has never set out precisely what he looks for in a moat, it is challenging to backtest his specific investment approach. However, a recent paper from the CFA Institute tries to shed some light on the concept of moat investing and how it links to investment returns.

The overriding aim of the paper from the CFA Institute is to understand the link between the popularity of investments and how popularity acts as a bridge between classical and behavioral finance.

One of the measures the authors use to define popularity is Morningstar’s so-called "moat ratings." These ratings are compiled by Morningstar using a “number of factors related to a company’s relative sustainable competitive advantage (considered a moat to deter competition), including network effect, intangible assets, cost advantage, switching costs and efficient scale. After considering all available information, companies are then grouped into three different moat brackets: wide moat, narrow moat or no moat.

A wide moat, the paper notes, is an “example of a characteristic that investors would nearly uniformly agree is good,” therefore improving the popularity of the investment. However, what I’m interested in is how these investments performed. In other words, do companies with a wide moat outperform the market, or is this something that investors should overlook when considering potential investments?

Do moats outperform?

The findings are highly fascinating. The authors of the paper looked at Morningstar’s moat ratings going back to 2002 when the data provider first started publishing the data.

The number of companies assigned moat ratings during this period varied widely, from 427 at the beginning of the experiment (July 2002) to 1,611 at the peak of the 2007/08 bull market. The average over the sample period was 1,039.

Moat businesses should outperform the competition over the long-term for two reasons. Firstly, they should be able to maintain a competitive advantage for longer, generating excessive profit margins and returning capital to investors.

Second, investors should be willing to pay more for wide-moat companies, both from a fundamental perspective and from a popularity perspective. As the authors opined, “We believe that investors prefer companies they consider to have a sustainable competitive advantage. Thus, wide-moat companies represent the most popular stocks and no-moat companies represent the least popular stocks.”

Disappointing return

The findings of this study are not as you would expect. As it turns out, no moat companies do not have a significant discernable advantage over wide moat companies. The data show, “in up markets, the lower the sustainable competitive advantage, the better the returns. During down markets, however, such as the 2008 financial crisis and the more minor downturns in 2011 and 2015, the greater the sustainable competitive advantage, the milder the downturn.”

The fact that wide moat businesses outperform in bear markets isn’t enough to improve long-term performance. The authors calculate that over the period studied, $1 invested in the three equally weighted moat portfolios would grow to nearly $10 for the no-moat businesses, compared to around $6-$7 for narrow and wide-moat businesses. The annualized alphas are –1.59% for the no-moat companies and 0.95% for the wide-moat companies. Neither alpha is above the statistically significant 5% level.

The findings of this paper are fascinating. They show that moat businesses are not necessarily better investments over the long term, although why this is the case is a more difficult question to answer. Still, it is valuable to know that just because a business looks to have a durable competitive advantage, does not guarantee that advantage will remain and it will prove to be a good investment.

Disclosure: The author owns no share mentioned.

About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

Visit Rupert Hargreaves's Website


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