The investment environment has been challenging lately in the face of soaring inflation, rising interest rates, and the ongoing war in Ukraine. During uncertain times, it is prudent to focus on tried-and-true investment principles that can strengthen risk-adjusted returns over the long term. Investing in companies that can maintain a decisive edge over rivals for 10 or 20 years is one such principle that can provide ballast to a portfolio during periods of heightened market volatility.
This focus is one of the key pillars of our investment strategy: emphasizing companies that have a sustainable competitive advantage—or a “moat” around their business—that enables them to fend off competitors across market environments and business cycles.
Here, we introduce the moat investing approach, discuss how it can benefit a portfolio in challenging market environments, and explain how a moat strategy can limit behavioral biases that can negatively affect portfolios over the long term.
What is Moat Investing?
Moat investing is a strategy that focuses on companies that possess key characteristics that provide them with ongoing protection against competitors. The moat label comes from the bodies of water that surrounded fortress-like castles during the Middle Ages and kept adversaries at bay. The wider the moat or the more moats a company has, the better chance it has of maintaining its competitive advantage for an extended period of time.
When pursuing a moat investing strategy, we look for companies that have moats with staying power. A company that is expected to maintain its competitive advantage for at least the next 20 years is viewed as having a “wide moat,” according to Morningstar—the firm that popularized the moat terminology. A “narrow moat” is a company that is expected to retain its edge over rivals for at least 10 years. Morningstar identifies five types of moats that give businesses a unique edge and provide them with a defensive buffer against adversaries:
- Cost Advantages: Companies that can source and sell products at lower prices than competitors and still maintain strong profit margins are able to undercut rivals on price while also boosting their own sales and market share.
- Intangible Assets: Companies with brand recognition, patents, or products that can’t easily be copied often are able to charge premium prices.
- Switching Costs: Companies may have pricing power because their products are so well-entrenched that customers find it too much of a hassle or too costly to switch to a competitor.
- Network Effect: Companies with products or services that increase in value when the number of users grows can build more sustainable revenue streams and pricing power.
- Efficient Scale: Companies sometimes dominate a market, such as railroads, utilities, and airlines, leaving little incentive for an upstart to enter the market.
The value of Moats when volatility is high.
Generally, a company whose sales and profit streams are growing solidly over the long term are viewed more favorable by market participants. In other words, they are perceived as built to last. As a result, companies with a moat-like advantage tend to hold up better from both an operating standpoint and stock price perspective during market downturns. Additionally, moat-like companies have the advantage of pricing power, which is the ability to pass higher costs to the consumer, something that is very valuable during inflationary environments.
But that doesn’t mean that a moat stock can’t fall in price due to overvaluation or negative news that causes investor sentiment to turn more cautious on equities in the short term. Stocks with sustainable competitive advantages, however, are more likely to withstand the challenging environment and rebound when the market recovers.
Another benefit: building a Moat around investors’ emotions.
No matter what your investment strategy or financial goals are, it takes discipline to stick to your plan—especially during periods of market volatility. Investing in moat stocks can help to offset the angst and uncertainty that comes with stock investing.
A big part of this advantage is that moat stocks generally are household names. Having familiarity with the name of a company and what the company does can limit an investor’s impulse to sell a position when markets broadly decline. If you embrace the moat stock investing strategy and understand that these companies have been vetted for sustainability in good times and bad, you will more likely have the confidence and conviction to stay the course and keep your long-term financial plan on track. If you are interested in learning more about how Leelyn Smith incorporates its moat investment strategy into your portfolio, please don’t hesitate to contact us.
Certain statements contained within are forward-looking statements including, but not limited to, statements that are predictions of or indicate future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties.
Opinions voiced are not intended to provide specific advice and should not be construed as recommendations for any individual. To determine which investments may be appropriate for you, consult with your financial professional.
Indices are unmanaged measures of market conditions. It is not possible to invest directly into an index. Past performance is not a guarantee of future results.
International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and differences in accounting methods. Past performance cannot guarantee future results.