An investing concept widely associated with Warren Buffett, feted CEO of Berkshire Hathaway, is to find companies with wide ‘economic moats’. Generally speaking, these are the kind of companies that have developed advantages allowing them to defend their profitability against encroaching competition.
A strong brand identity (created through advertising and marketing expense) might be one example of an economic moat; ownership of robust patents (created through research and development spending) might be another. Coca-Cola, in which Berkshire Hathaway has had a long-standing stake, is a notable example of the former; pharmaceutical companies are an example of the latter.
But do share prices always reflect the value to be found in wide-moat firms? One reason to suspect that they might not be is standard accounting treatment and the way it categorises these kinds of businesses. Here, the expense of ‘moat-building’ is generally counted in the here and now rather than being capitalised over a period of years. This lowers a firm’s income and thus appears at first glance as value ‘destruction,’ not value creation. A more enlightened accounting treatment appreciates that such spending can create lasting value for the firm and improve profitability for many years to come.
In 2023, the MDT team added an economic moat factor to our model that seeks to capitalise on a company’s spending on potential moat-building activities. We then aggregate estimated moats across a company’s industry to smooth out inequalities in individual company data reporting and call the resulting factor ‘industry moat.’
This ‘industry moat’ factor has helped us most in improving stock selection among highly out-of-favor stocks — which are not precisely the same thing as value stocks, although there tends to be a substantial overlap. Our research has indicated that stronger return potential among out-of-favour stocks is associated with those having a wider economic moat. In other words, companies in narrow-moat industries that offer commoditised goods or services with low value-added features (e.g., banks, airlines, mining) are less likely to rebound from a negative shock than those in wide-moat industries (e.g., software, retailing, pharmaceuticals).
We believe the industry moat factor works particularly well within our investment process. Companies with high market sentiment, those that are beating earnings estimates quarter after quarter, or those with other strong quality characteristics are typically already well appreciated by the market. So, the presence (or lack) of a wide economic moat tends not to significantly impact expected returns for those companies.
However, even successful companies can fall out of favour for various reasons, some within their control, but others beyond their control. An established moat can help out-of-favour companies keep competitors at bay while re-establishing operating results. Thus, we have begun to use this factor to help identify those companies that are more likely to overcome negative sentiment/momentum to return to in-favour status, seeking to avoid companies whose stock prices continue to tailspin. We believe it helps us identify wonderful companies at wonderful prices.
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