Making the moat of it

An investing concept widely associated with Warren Buffett, CEO of holding company Berkshire Hathaway, is to find companies with wide "economic moats." Generally speaking, these are companies that have developed advantages allowing them to defend their profitability against encroaching competition.

A strong brand identity (created through advertising and marketing expense) might be one example of an economic moat; ownership of robust patents (created through research and development spending) might be another. Coca-Cola, in which Berkshire Hathaway has had a long-standing stake, is a notable example of the former; pharmaceutical companies are an example of the latter.

But do share prices always reflect the value to be found in wide-moat firms? One reason to suspect that they might not be is how standard accounting treatment categorizes these expenses. The expense of "moat building" is generally counted in the here and now rather than being capitalized over a period of years. This lowers a firm's current income and thus appears at first glance as value "destruction," not value creation. A more enlightened accounting treatment appreciates that such spending can create lasting value for the firm and improve profitability for many years to come.

In 2023, the MDT team incorporated a new factor into its model that seeks to capitalize on a company's spending on potential moat-building activities. We aggregate estimated moats across a company's industry to smooth out inequalities in individual company data reporting and call the resulting factor Industry Moat.

We believe the Industry Moat factor can help us most in improving stock selection among highly out-of-favor stocks-which are not precisely the same thing as value stocks, although there tends to be a substantial overlap. Our research has indicated that stronger return potential among out-of-favor stocks is associated with those having a wider economic moat. In other words, companies in narrow-moat industries that offer commoditized goods or services with low value-added features (for example: banks, airlines, mining) are less likely to rebound from a negative shock than those in wide-moat industries such as software, retailing, pharmaceuticals.

We believe the Industry Moat factor works particularly well within our investment process. Companies with high market sentiment, those that are beating earnings estimates quarter after quarter, or those with other strong quality characteristics are typically already well appreciated by the market. So, the presence (or lack) of a wide economic moat tends not to significantly impact expected returns for those companies.

However, even successful companies can fall out of favor for various reasons, some within their control but others beyond their control. An established moat can help out-of-favor companies keep competitors at bay while re-establishing operating results. Thus, we have begun to use this factor to help identify those companies that may be more likely to overcome negative sentiment/momentum to return to in-favor status, seeking to avoid companies whose stock prices continue to tailspin. We believe it helps us identify, to paraphrase Buffett, wonderful companies at wonderful prices.