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: MOAT) exchange-traded fund (ETF), 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 Coca-Cola (NYSE: KO), Cisco Systems (Nasdaq: CSCO), eBay (Nasdaq: EBAY) and Bank of New York (NYSE: BNY). 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.
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To be fair, this fund's sponsors, Market Vectors, are a bit constrained as they can only choose from companies that Morningstar (Nasdaq: MORN) 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 Facebook (Nasdaq: FB), Caterpillar (NYE:CAT) and Amgen (Nasdaq: AMGN) 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 sledding.)
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 Qualcomm (Nasdaq: QCOM) and BlackRock (NYSE: BLK).
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.
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1. Leading and sustained market share. Ball Corp. (NYSE: BLL), 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 profit margins.)
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 as Amcor (Nasdaq: AMCR) and Crown Holdings (NYSE: CCK) 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: Google (Nasdaq: GOOG), 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.
Whirlpool (NYSE: WHR) 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 automation.
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Risks to Consider: The biggest risk to wide moats can be technological change. IBM (NYSE: IBM) and Olivetti once had a tight grip on the typewriter market -- at least, until people stopped using typewriters. The wide moat that Coca-Cola and PepsiCo (NYSE: PEP) had is being frittered away by do-it-yourself soda makers such as SodaStream (Nasdaq: SODA).
Action to Take --> To find other wide-moat companies, focus on smaller industry niches that are sometimes supported by just one or two players. Calgon Carbon (NYSE: CCC), 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.