Wide moat beats narrow or no moat investing in the long run

When a new investor starts his journey in picking stocks, very often no thought process is given to the economic moat or management quality of the company.

What is economic moat?

An economic moat is a concept popularized by Warren Buffett, describing a company's sustainable competitive advantage that allows it to maintain its market position and fend off competition. Similar to a castle's moat protecting it from invaders, an economic moat protects a company from competitors trying to erode its profits and market share.

There are several types of economic moats that can contribute to a company's competitive advantage:

Cost Advantage: When a company can produce goods or services at a lower cost compared to its competitors. This could be due to proprietary technology, efficient processes, access to cheaper resources, or scale advantages.

Network Effect: Companies benefit from a network effect when their product or service becomes more valuable as more people use it. Social media platforms and online marketplaces are examples where the more users they have, the more useful they become, creating a barrier for new entrants.

Intangible Assets: Intellectual property, such as patents, trademarks, brand recognition, and regulatory approvals, can provide a significant competitive advantage. These assets are difficult for competitors to replicate quickly.

Switching Costs: Some companies build moats by making it expensive or inconvenient for customers to switch to a competitor. This can be through contracts, specialized equipment, or unique services.

High Barrier to Entry: Industries where significant investments in infrastructure, technology, or regulatory hurdles are required tend to have higher barriers to entry. This makes it challenging for new competitors to enter and compete effectively.

Economies of Scale: Larger companies can benefit from economies of scale, meaning their cost per unit decreases as production volume increases. This can create a significant advantage over smaller competitors.

A company with a strong economic moat tends to generate sustained profits and returns over an extended period. Investors often seek businesses with robust moats because they offer more predictability and stability in their earnings and are less susceptible to competitive pressures.

Morningstar found that companies with a wide moat outperform its peers with narrow or no moat

At investment research & rating firm Morningstar, they cover around 1,500 companies, and of that only fewer than 8% or 130 companies have both a wide Morningstar economic moat and earned an exemplary Captial Allocation Rating, which is a measure of management quality.

When investors are forced to choose between economic moats and management quality, moats win out in the long run.

From Morningstar's data, in a sample of nearly 1,000 companies that Morningstar equity analysts have covered from 2017 through today, only 13 stocks were assigned an Exemplary Capital Allocation Rating alongside no moat. But despite the rarefied air, these firms saw their median performance underperform wide-moat stocks with Standard- or even Poor-rated capital allocators at the helm.

One important point to note is that despite the moat, the valuation is also an important factor. If the investor over pays or buys a stock that is currently over valued, eventually the stock will correct to its fair value over time.

There are many ways to value a stock, for example working out a discounted cash flow model, or using PE ratio, EV/EBITDA ratios, etc.

The important part is to be able to find companies that have wide moats and are currently under valued.

One way is to take Morningstar's fair value (which is obtainable by a subscription) and then work out your own calculations.

Currently here are some of the fair values & moats of the magnificent seven:

Apple $150 ⭐️⭐️ (wide moat)

Microsoft $370 ⭐️⭐️⭐️ (wide moat)

Alphabet $161 ⭐️⭐️⭐️⭐️ (wide moat)

Amazon $155 ⭐️⭐️⭐️ (wide moat)

Meta $322 ⭐️⭐️⭐️ (wide moat) 

Nvidia $480 ⭐️⭐️⭐️ (wide moat)

Tesla $210 ⭐️⭐️⭐️ (narrow moat)

@CaptainTiger 

@TigerStars 

$Amazon.com(AMZN)$ 

$Apple(AAPL)$ 

$Microsoft(MSFT)$