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The power of moat investing

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FundForum 365 talks to VanEck’s Philipp Schlegel about the benefits and simplicity of moat investing.

The term ‘economic moat’ was coined by legendary investor Warren Buffett in 1999 to refer to companies with a long-term advantage over their competitors. Just as the moat around a medieval castle served as a vital form of defense against marauders, economic moats are sustainable competitive advantages that keep competitors at bay, protect their business model and create steady earnings.

But what are economic moats, and what do they have to do with corporate performance?

Defining the economic moat

Investors are no doubt familiar with conventional moats — the defensive trenches dug around castles and filled with water in medieval times to foil invading armies and discourage attacks. Castles with wider moats were more difficult to attack than those with narrower moats.

"VanEck has become a strong proponent of moat-based strategies, especially for investors looking for something more sophisticated than traditional index tracking and more consistent than smart beta or factor investing."

Economic moats, then, are metaphors used to represent the competitive advantage that a company may have versus the rest of the competition in its industry.

“The wider the moat, the greater the competitive advantage that a given company enjoys. The narrower the moat, the more competitive the industry,” says Philipp Schlegel, Managing Director International Business Development with global asset manager VanEck.

What are the benefits of economic moats?

Naturally, only companies with specific sets of characteristics can enjoy the benefits of economic moats. These characteristics include:

  • Intangible assets: a strong brand with high customer loyalty tends to be able to continue charging a premium for its products (and consequently experiencing higher profit margins), even though cheaper alternatives are available.
  • Switching costs: when it is difficult or extremely costly for existing customers to switch from their existing provider to another, companies can continue to charge a premium for their products or services, even amidst robust competition.
  • Network effect: social networks such as Facebook serve as excellent examples of this characteristic. While many alternatives to Facebook exist, its 1 billion active users present a formidable “network effect” cost to any users considering switching to another platform. The platform is useful insofar as it provides users with access to its large user base and presents a nearly insurmountable obstacle to would-be competitors.
  • Cost advantage: companies that have managed to lower costs to a degree beyond the reach of the competition may enjoy higher profit margins even as they are able to charge significantly lower prices.
  • Efficient scale: companies that have come to dominate niches with near-monopoly reach can also generate higher-than-usual profits as a result.

Companies with just one or even a collection of the above characteristics will tend to have wider moats and greater competitive advantages, enabling above average profits over sustainable periods of time.

Refining the concept

Independent investment research company Morningstar has looked to refine the moat concept by developing a dedicated rating methodology ranging from “wide moat” for companies likely to sustain their advantage for twenty years or more, “narrow moat” for at least ten years and “none” for those with either short-term or no structural advantages.

In the first phase of stock selection, more than 100 analysts at Morningstar — the renowned, independent research firm — systematically screen all of the approximately 1500 stocks contained within the Morningstar US Market Index, which accounts for 97% of U.S. stock market capitalization.

If a company benefits from one or more competitive advantages and is deemed capable of sustaining them over the next twenty years, the stock receives a “Wide” Morningstar® Economic Moat™ Rating. Currently, about 219 companies from the 1500-stock universe have earned this rating.

"Economic moats, then, are metaphors used to represent the competitive advantage that a company may have versus the rest of the competition in its industry."

From there, companies with “Wide” economic moats are further screened for fair value utilizing a proprietary assessment methodology that takes cash flow and profit estimates into account. The remaining 40 to 80 securities — representing attractively-priced U.S. securities with wide economic moats — are included in VanEck’s moat investing portfolios.

Schlegel believes that moat investing is both a smart strategy and one that is easy to replicate, particularly when combined with the concept of fair value. “It creates the potential of above-average earnings over a longer period,” he says. “It also gives investors exposure to equities that trade at attractive valuations.”

Smart beta and factor investing have been popular strategies in recent years and while Schlegel believes that moat investing belongs in the same conversation, there are some fundamental differences. Whereas the former two concepts are based on historical data, moat investing is very forward-looking.

“Morningstar’s equity research analysts assess quality and valuation by looking into the future,” says Schlegel. “On the quality side, they assign economic moat ratings, which determine whether a company can sustain a competitive advantage for ten or twenty years into the future. And their valuation research projects cash flows to arrive at a current intrinsic share value.”

VanEck has become a strong proponent of moat-based strategies, especially for investors looking for something more sophisticated than traditional index tracking and more consistent than smart beta or factor investing.

Important Disclosures; This article originates from VanEck Investments Limited (“VanEck) and does not constitute an offer to sell or solicitation to buy any security. VanEck only serves investors in countries were the funds are registered or were they can be sold in accordance with local private placement rules.

Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. Forecasts, estimates, and certain information contained herein are based upon proprietary research and the information contained in this article is not intended to be, nor should it be construed or used as investment, tax or legal advice. VanEck and its associated and affiliated companies assume no liability as regards to any investment, divestment or retention decision taken by the investor on the basis of this article.

Morningstar® Wide Moat Focus IndexTM is a trade mark of Morningstar inc. and has been licensed for use for certain purposes by VanEck. VanEck’s products are not sponsored, endorsed, sold or promoted by Morningstar and Morningstar makes no representation regarding the advisability of investing in these products.

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