Emerging markets have more companies with a narrow moat
Morningstar Australasia’s Heather Brilliant talks about implementing the concept of economic moats in investment management
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Heather Brilliant, chief executive officer, Morningstar Australasia, was recently in Mumbai attending the 7th India Investment Conference organized by the CFA Institute and CFA Society India. Brilliant has been with the independent research and financial securities data analysis firm for over 13 years and has spent time researching, investing and strategizing. She is also well regarded in propagating and implementing the concept of economic moats in investment management. She has also co-authored a book on this subject. We caught up with Brilliant on the sidelines of the conference and spoke in detail about the application of economic moats in stock picking across sectors and geographies. Edited excerpts:
How do you identify an economic moat (refer to De-jargoned: the concept of economic moat) in a company? What are the specific attributes in a company that contribute towards this?
For any company that we think has an economic moat, we look for one of the five sources of that moat. One of these is the presence of intangible assets: do they have a brand that people are willing to pay a premium for? We try to quantify the premium that people are willing to pay for that brand.
Another thing we look for is whether the company has a cost advantage and that is probably the easiest to quantify. You can usually tell just by looking at the financial statements whether they can produce at a discount relative to competitors.
The third one is switching costs. For this, we look at renewal rates in customer relationships, to uncover if the customer has a switching cost.
If you think about Infosys Ltd, for example, they have more than 95% of the business coming from their existing client base, thanks to repeat business. This happens because the client knows that Infosys already knows the company’s business and technology. Even though there are many other providers, the cost and hassle to shift is too great.
Network effect is another example we look for. This is really where Facebook or Alibaba or Amazon come in—the more people who are using the network, the more valuable it is. These are recent examples, but the phenomena is not recent—Visa and MasterCard are great examples of the network effect.
The last one is called efficient scale, which is the idea that some markets are not large enough to support another competitor.
For example, in Australia there are a lot of businesses that earn excess returns on capital but it was hard to understand why—because the business itself was very basic, like retail.
We realized it’s because the market is just not large enough for global competitors to come in. So you are addressing a limited market and where competitors are unlikely to enter, as the economics gets disrupted for both.
Is there a direct correlation between a good stock (returns generated) and the economic moats identified for the company?
Another really important factor along with the moats is the valuation. Even if there is a very strong moat, but you buy the company when the stock is expensive or highly priced, you don’t see excess returns over time. It’s a combination of buying high-quality businesses and buying them at a discount.
Any such ideas in the Indian equity market that may not have worked despite the presence of a moat?
One that we think has a wide moat is Hindustan Unilever Ltd, partially because they leverage the global brand and there is a lot of consumption growth.
Another one is Infosys, which has a narrow moat and we think is undervalued.
To contrast these, there is Dr. Reddy’s Laboratories Ltd, which has a narrow moat and a really good business but we think it’s overvalued at the current price. We don’t think it’s a good time to buy that stock but a good one to have on your radar.
Can you please explain the concept of wide and narrow moats?
A wide moat is where we think the excess return on capital can be achieved for the next two decades, and that is very hard to achieve. There are only about 200-250 companies globally that we give a wide moat rating to.
Narrow moat means we expect excess returns for the next 10 years. It’s still a long time and hard to attain, but it’s much more available.
Does the way you identify a moat change when looking at companies in different sectors?
Yes. It changes because the sources of moats are different in different sectors.
If you look at basic materials or energy companies, they are price takers. Hence, their main advantage comes from cost or being a low-cost producer.
Generally, they can’t leverage a better brand. But if you look at an industry like health care we find a lot of companies with wide moats, where there are patent protections.
Here, based on government approvals, there is an ability to generate excess return for an extended period of time.
At the same time, a pharmaceutical company with a single product would not have an economic moat.
The way we really see it working is that for a large pharmaceutical company, what’s important is the way they can layer in their research and development (R&D) and pipeline: they constantly have some portion of their income coming from branded drugs.
Are there any businesses that never qualify?
In terms of areas where there is never a moat, it’s really hard for us to find a retailer with a moat.
There is no switching cost and it’s easy for people to move to another. Although, even here there have been exceptions over time.
The parent company for the brand Zara, Inditex, has a very unique operating model in terms of how they design their fashion and get it through their inventory.
They can basically copy whatever fashion is on now and have that on their shelf in two days.
They don’t have to think of fashion because they can react so quickly, which gives them an advantage.
I am unsure if we cover that stock or if it has a moat, but that’s the kind of thing we look for. If there is a unique business that doesn’t fit anything else around and the financial numbers give us a reason to dig in further, that’s what we want to see.
Is the concept applied differently in developed versus emerging market economies?
We definitely find that wide moat businesses are more likely in developed markets. In emerging markets, we find a lot of narrow moat companies. In India too, we find a lot of narrow-moat companies. Part of this is thanks to the predictability of returns and growth patterns.
If you have a business with a track record of consistent earnings growth and return on capital, and you can predict how that will move in the future, thanks to understanding the competitive landscape better, then it’s easier to say that this could be a wide-moat business.
In an emerging market there are many changes, including: consumer preferences, constant innovations and new ideas. It’s hard for any company to survive in the same way for the next 20 years; it’s easier to predict this for a 10-year period.
What are the signs to watch out for if a company is losing its moat?
We try to look for situations where the competitive position is not as strong. Ideally, you want to predict that before it comes through in the numbers. One example of that is Microsoft. This is a company with a wide moat but it has a negative trend rating.
Even though we think it has a good cash flow base from all the enterprise software agreements, we are finding that on the margin with their new businesses, they are facing a lot more competition and these businesses aren’t generating as much return as compared to their historical business.
If you just look at the financials, you wouldn’t know there is an issue but if you really dig into it, the new effort that they are funding is not yielding the same results.
Lisa Pallavi Barbora