The notion of a wide moat around your castle has been around
for centuries. The early moats were designed to repel rivals and
prevent them from invading and conquering.
Today's moats also keep rivals at bay. Companies that have
built a solid moat around their business, limiting the threat of
competition and price wars to some degree, tend to garner higher
valuations from investors.
How do we know that? Because the
Market Vectors Wide Moat ETF (NYSE:
exchange-traded fund (
), which debuted in April 2012, is handily outperforming its
benchmark, the S&P 500 Index.
The question for investors: Is it better to own this fund, or
to try to find your own companies with solid moats? To answer
this, let's first look at how this ETF is constructed.
Unlike many ETFs that own a tiny slice of hundreds of companies,
this ETF has a roughly 5% weighting in just 20 companies. In the
portfolio, you'll find household names such as
Cisco Systems (Nasdaq:
Bank of New York (NYSE:
. It's immediately clear why companies like Cisco or eBay get the
nod as they possess the products and financial resources to keep
competitors at bay. On the other hand, Coca-Cola and the Bank of
New York are often hemmed in by tough competition. So determining
what constitutes a wide moat is clearly subjective.
To be fair, this fund's sponsors, Market Vectors, are a bit
constrained as they can only choose from companies that
determines to have a "sustainable competitive advantage." The
folks at Market Vectors simply adjust the portfolio to represent
the most attractively priced stocks in that universe.
Here's a look
at the most recent changes to the universe, as determined by the
folks at Morningstar.
You'll notice that companies such as
were recently removed from the group. In each case, these stocks
reached what Morningstar determines to be fair value. (In the
case of Facebook, for example, shares appreciated up to fair
value, while in cases such as Caterpillar, the perceived fair
value was lowered as the equipment maker hit rough operational
You'll also notice that Morningstar suggests which companies
will be candidates for inclusion the next time this universe is
re-constituted. The only companies in that group that possess
truly wide moats, in my view, are
Make no mistake: This is an attractive ETF with a solid track
record and a reasonable 0.49% expense ratio. But it doesn't
really help us to find young, fast-growing companies with solid
moats around them.
To find these companies, you need to pursue qualitative
measures. Here are several key ingredients that go into the
fortification of a wide moat.
1. Leading and sustained market share.
Ball Corp. (NYSE:
, which controls more than 30% of the global aluminum can market,
tends to set industry pricing trends. Its highly efficient cost
structure allows it to take market share with aggressive prices,
or pursue broader profit margins when price wars cool off. (
This academic study
sheds some light on the relationship between market share and
2. Industry-leading margins.
You can see the impact of Ball's market share strength in its
operating profit margins, which typically exceed 9%. Rivals such
Crown Holdings (NYSE:
must make do with margins that are several points less.
3. Niche markets.
Of course, Ball still faces competition, which means it has a
good but not great moat. A truly great moat only comes when a
company fully controls the market, often with market share in
excess of 50%. A great example:
, which controls nearly two-thirds of the search engine market.
Google has used that pole position as a cudgel to drive gains in
its newer and younger product lines.
is another wide-moat firm. Two out of every five household
appliances (washing machines, dishwashers and clothes dryers) are
made by Whirlpool (with names such as Maytag, Amana and
Kitchen-Aid). That massive market share enables Whirlpool to reap
massive scale economies in terms of R&D spending and factory
Risks to Consider:
The biggest risk to wide moats can be technological change.
and Olivetti once had a tight grip on the typewriter market -- at
least, until people stopped using typewriters. The wide moat that
had is being frittered away by do-it-yourself soda makers such as
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To find other wide-moat companies, focus on smaller industry
niches that are sometimes supported by just one or two players.
Calgon Carbon (NYSE:
, for example, supplies most of the scrubbers used coal-fired
power plants. Although demand is subject to energy industry
trends, Calgon Carbon has a solid grip on pricing.
Young companies that quickly establish a wide moat often
become buyout fodder. Skype was launched in 2003 and bought by
eBay two years later for $2.5 billion. (And subsequently bought
by Microsoft in 2010 for $8.5 billion.) That's why it pays
to track young companies that develop ground-breaking new
products no one else has thought of before.