First Quarter, 2019
On October 3, 2018, the Dow Jones Industrial Average (DJIA) closed at an all-time high of 26,828.39 … up 8.5% from its December 31, 2017 close of 24,719.22.
A correction is marked by a decline of at least 10% but not more than 20%. Whereas, a bear market is marked by a decline of at least 20% with the average decline being 30%. Most corrections do not become bear markets.
Then, the year’s “more-normal-than-not” volatility morphed into a full-blown correction, sending the DJIA down 13% from its high to close the year at 23,327.46 … down 5.6% from the prior year-end. The other indices told a similar story.
Although corrections can be plenty nerve-wracking, they are a normal market phenomenon. In effect, they cause investors to re-evaluate their behaviors and expectations, and get them in-line with reality. As noted in our last The Markets, experienced investors know that pullbacks and corrections (and even bear markets) spell opportunity not doom. Also, they know that a well-diversified portfolio of high quality stocks provides better protection during such trying times. So, how do you discern “high quality”?
Wide Moats: Defending Castles and Companies
In medieval days, feudal lords surrounded their castles with moats to defend their people and property from rival lords and bands of marauders. Suffice it to say … the bigger the moat, the better the defense and more secure the lord and his fiefdom.
The same concept can be applied to companies and investing. In November 1999, investment legend Warren Buffett and journalist Carol Loomis penned a column for Fortune magazine. In it, Buffett coined a new and important investment term, “wide moats”, when he said:
“The key to investing is determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”
This is a great article and well worth the read especially when you consider the “dot.com” bubble burst on March 10, 2000. Despite the Buffett legend, it’s one thing for him to state the theory and another for it to be tested. Well, researchers have tested it and here’s what they found.
Companies with moats share one or more of these key attributes:
- Economies of Scale. Some companies can produce their goods or services at a lower cost than their competitors. This allows them to achieve higher profits or lower prices to increase market share. In turn, the more customers they attract, the more they can boost profits by lowering their costs.
- High Customer-Switching Costs. Other companies cement client relationships by keeping the cost of switching to a competitor high. Your bank is a great example. Imagine how much time you might spend changing your automatic deposits and bill payments.
- Intangible Assets. Some companies can block competition or charge a premium price because they’ve built their brand, secured patents and trademarks, obtained government licensing or approvals, or built a unique corporate culture. This allows them to safeguard their goods or services, and build customer trust and loyalty.
- Network Effect. Other companies offer goods or services that increase in value for everyone as more and more people start using them. And, the more they’re used, the harder it is to reproduce them.
Not all moats are created equally.
Companies with “wide moats” have competitive advantages that are sustainable for 20 years or more. But, they’re a rare breed. For example, a Morningtar study found that only 10% of the 1,500 stocks they cover have wide moats, whereas 48% have “narrow moats” (sustainable advantages for 10-20 years) and 42% have no moats.
Long-term, companies with wide moats perform better than those with narrow or no moats.
Research shows that wide moat companies perform better than narrow moat or no moat companies. Specifically, they produce higher returns with lower volatility, as measured over a 10-year period. Similarly, narrow moat companies have higher returns and lower volatility than no moat companies.
Our investment philosophy is simple. If you combine high quality investments and a long-term, disciplined approach, performance will take care of itself. Not surprisingly, about 65% of the companies we hold in client portfolios are wide moat companies.