Investors need to study competitive moats closely to determine whether companies have what it takes to continue growing over the long term.
Morningstar’s “Why Moats Matter” book helps detail the various competitive moats.
We started by introducing several different intangible moats in the first part.
The second part then described four other types of competitive flukes.
This discussion, however, will not be complete without looking at fluke trends.
Moat trends assess how moats change and evolve, and are important because the business world is dynamic.
The only constant being change, companies can see their moats grow stronger or weaker over time.
If a company’s moat erodes over time, it will have serious consequences for the investor.
Morningstar uses three types of ratings: positive when the fluke is strengthening or growing, negative when the fluke is shrinking or shrinking, and stable when there is no perceptible movement in either direction.
Let’s take a closer look at these three categories.
Positive fluke trend
Companies with positive moat trends are those that have spent time, resources, and effort to strengthen their competitive moat.
How do investors assess this?
The stronger moat will manifest itself in higher return on invested capital, better margins and healthier free cash flow generation over time.
The process of strengthening a moat can be active – for example, a company undertakes research to provide a better customer service experience and increases its switching costs.
It may choose to strengthen its network of products and services by integrating more suppliers and customers, thus strengthening its network effect.
Some moat trends are positive due to passive events over which the company has no direct control.
Examples include a competitor (who offers a substitute product) that goes bankrupt.
The industry in which the company operates could also expand and attract more attention.
Competing technologies can either be left out or excluded from consideration, thus strengthening the company’s moat without it taking any active action.
Negative fluke trend
Moat erosion is quite a common occurrence due to the pace of change in today’s business world.
Companies that cannot quickly adapt to change risk seeing their competitive moats crumble over time, exposing them to competitive attack.
Management can also be complacent when times are good and rest on their laurels.
This can happen when a company has held a dominant position in the market for years or even decades.
Rapid advances in technology can displace some moats while replacing others.
One example is the rapid adoption of online news, which is causing print media to take a step back and lose its top spot as the top choice for news.
Healthier lifestyles and growing awareness of diabetes may also reduce the number of people who drink sugary sodas such as those sold by Coca Cola (NYSE: KO).
Businesses need to be constantly vigilant and aware of these potential changes.
Stable fluke trend
Stable fluke trends are the exception rather than the rule these days.
The advent of the internet and rapid technological advancements are to blame for supplanting many competitive moats over the years.
However, it is still possible to find companies in consumer goods industries with stable trends.
These are industries where the risk of technological disruption is low and where companies have also built up a loyal customer base that is unlikely to embrace new changes.
Some examples include popular toiletry brands by Procter and Gamble (NYSE: PG) and napkins and tissue paper produced by Kimberly Clark (NYSE: KMB).
These consumer giants have an upper hand for their big brands that probably won’t be dethroned anytime soon.
In the next part of this series, we look at several factors that influence moat trends and whether they translate to a more or less attractive business.
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Disclaimer: Royston Yang does not own any of the companies mentioned.