So much of what we do as investors comes down to making good predictions, so can we make better forecasts or estimates by knowing if moats exist and how strong they are?
The writing team behind “Why Moats Matter: The Morningstar Approach to Stock Investing”—contributor Warren Miller, head of quantitative research at Morningstar (MORN, Financial), and lead authors Heather Brilliant and Elizabeth Collins—makes this question the focus of chapter seven. The authors wrote, “is it worth precious time to dive deep into the intricacies of the moat framework? In this chapter, we use some simple statistical analysis to examine what our moat ratings can tell us about stock returns.”
Those ratings began in 2002, so by the time this book was published in 2014, there were a dozen years of data to bring to the question. And they had a clear but nuanced answer:
“Through our research, we’ve found that wide-moat stocks exhibit less downside risk and less upside potential. In times of market fear or distress, wide-moat stocks outperform no-moat stocks, but then underperform when risk aversion subsides. The evidence isn’t quite strong enough to claim that all wide-moat stocks generate excess risk-adjusted returns, but we do find that undervalued wide-moat stocks have done so. We think it’s safe to say, then, that the moat rating is a valuable risk-management and security-selection tool, especially when used in conjunction with valuation-based metrics.”
To illustrate their points, the authors created a table showing “Marginal Distributions of Future Monthly Returns by Moat Rating.” Anticipating that some readers would question the use of a one-month horizon, they offered a two-point explanation.
The first is that a direct mathematical relationship exists between short-term and long-term returns. (“Long-term returns are the geometric mean of the short-term returns that compose the same period.”) The second is that even long-term investors may revisit their portfolio balances once a month. This is the table:
What did they, and what can we, learn from the table?
- Mean: No difference among the one-month returns, regardless of the moat width.
- Standard deviation: These data show how far from the mean that returns might go among narrower moat companies; higher numbers mean greater volatility, which translates into higher risk and higher potential returns.
- Skew: “We see that no-moat stocks have the largest skewness, so the variation from the mean return is more likely to be a positive variation for no-moat stocks than for wide-moat stocks. This makes sense from an economic perspective given that wide-moat stocks tend to be more mature businesses.”
- Kurtosis: Refers to the “fatness” of a distribution’s tails (at the outer edges of a bell curve). Because kurtosis is quite high for no-moat stocks, they are more likely to be affected by extreme events, compared to narrow and wide-moat stocks.
Bottom line, no-moat stocks show far more dispersion (volatility) than wide-moat stocks, but do not deliver better expected returns. The authors concluded the risk-reward profile for no-moat stocks has not been promising.
What the table has not shown is the effect of time, how each moat group performs over time. And the result was, “wide-moat stocks don’t outperform on a risk-adjusted basis over all time periods.” One notable period was the financial crisis of 2008. Wide moats enjoyed a very strong advantage as investors fled to safety. But then as the crisis faded and stocks rebounded, wide moats lost some of their luster.
For many of us, wide-moat stocks would seem, intuitively, more appealing because they allow us to sleep at night while earning decent returns. The authors, though, say a wide moat by itself is not enough to deliver higher risk-adjusted returns in the long run; there is something missing, and that is the purchase price of the stock.
They argue you can expect undervalued stocks to earn positive risk-adjusted returns, while negative risk-adjusted returns will be more likely from overvalued stocks.
Added to that is the discovery the accuracy of their valuations varied according to the width of the moat; specifically, their valuations were better for wider moats and vice versa. This is a useful find for all investors who use discounted cash flow analysis or otherwise try to assess the future of a company.
Summing up, the authors found that a wide moat can help investors look forward more confidently. A wide-moat company, bought at a discount price, is the most likely to generate what has been called “excess risk-adjusted returns.” On the other hand, a no-moat company bought at anything above fair value is much less likely to generate those positive returns. Whatever the details, knowledge of moats can help investors make better predictions.
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