In our writing here we’ve made clear the the single most important element of our investment approach is focusing on companies that have a wide competitive moat. Usually when people talk about different kinds of moats, they are referring to the elements of the business model that give rise to the company’s competitive advantages. These concepts, like being the low cost producer, having proprietary intellectual property or exhibiting network effects, have been well documented by many writers. Morningstar’s book Why Moats Matter offers an excellent overview. But just as important is the different types of opportunities that different types of moats can afford companies.
Our friend Connor Leonard who runs the public market portfolio at Investors Management Corporation has developed an excellent framework for thinking about moat outcomes.
Connor explained his thinking in two posts on Base Hit Investing last year, which you can read here and here. Here’s a quick overview:
Low/No Moat: Companies that may be perfectly well run and sell good products/services, but which do not exhibit characteristics that prevent other companies from competing away there profits if they start earning attractive returns. Most companies fall into this category.
Legacy Moat-Dividend: A company that is insulated from competition, but does not have much opportunity to grow through reinvesting cash flow. So they pay most of their cash earnings out as dividends.
Legacy Moat-Outsider: A company that is insulated from competition, but does not have much opportunity to grow through reinvesting cash flow. So they deploy their cash flow in service of acquiring other companies as well as paying dividends and opportunistically buying back stock, as described in the book The Outsiders.
Reinvestment Moat: A company that is insulated from competition and has the opportunity to reinvest their cash flow into growing the business.
Capital-Light Compounder: A company that is insulated from competition and has the opportunity to grow, but which doesn’t need to reinvest much cash to do so and is therefore able to return cash to shareholders even while growing.
Our approach to investing is very similar to Connor’s and we thought it would be worth looking at our approach and portfolio holdings through his framework.
We strive to avoid investments in this category. Morningstar, which rates companies based on an assessment of the quality of their moat, only assigns a Wide Moat rating (their top rating) to 10% of the companies they cover. But they assign the Wide rating to about 67% of the stocks in our portfolio and give a Narrow moat rating to another 28% (these percentages exclude the few companies in our portfolio that they do not cover).
We believe that Low/No Moat companies are so subject to the competitive nature of the markets in which they operate that their future is far more governed by luck than by conditions within their control. There’s no doubt that the stocks of these companies can experience periods of fantastic performance. And those that are in the right place at the right time can generate massive returns for shareholders. But we systematically avoid investing in these companies because we don’t believe we have any particular edge in understanding when is the best time to own them.
Note that Morningstar does rate our holding in National Oilwell Varco (NOV) as having No Moat. However, until 2015 they rated the company as having a Wide Moat. As oil prices fell, they downgraded the rating first to Narrow and then final to No Moat as a new analyst picked up coverage. We believe that this analysis is flawed.
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