Warren Buffett is often thought of as a value investor, yet what he actually looks for is companies with ‘economic moats’ or a sustainable competitive advantage over their competitors.

‘When you have a wonderful business, it’s like having an economic castle, but the nature of capitalism is people want to come in and take your castle, so what you need is a castle with some durable competitive advantage, one with a moat around it,’ says Buffett.

While this sounds sensible, how can you as an investor decide whether a business has a good ‘moat’ or not?

WHAT IS AN ‘ECONOMIC MOAT’?

Capital tends to flow to where returns are the highest, so if a company starts up and is generating amazing profits it will only be a matter of time before another company starts up doing the same thing and tries to grab some of the pie.

For a company to defend its returns, it has to have a product or service which is so good it compels customers to return time and again rather than go to one of its rivals.

Research and ratings group Morningstar defines an economic moat as ‘a durable competitive advantage that allows a firm to keep competitors at bay and generate economic profits over an extended period’.

To help investors identify companies which possess an economic moat, Morningstar’s equity research team assigns one of three ratings: ‘wide’, ‘narrow’ or ‘none’.

For a company to earn a moat rating of ‘wide’, it has to satisfy two major criteria: it must be likely to generate returns on invested capital above its weighted average cost of capital for at least the next 20 years; and it must enjoy one or more economic ‘moat source’ giving it a structural competitive advantage.

Qualities which help support a moat include:

A network effect — This is when the value of a network increases for new and existing users as the network grows.

A cost advantage — This allows a firm to sell at the same price as its rivals but still enjoy economic profits thanks to lower unit costs of production.

Efficiencies of scale — When a company serves a market which is limited in size, new competitors may not have an incentive to enter, especially if the cost of entry is high. New entrants would cause returns for all players to fall well below the cost of capital.

Intangible assets — This could be brands, patents or regulatory licenses which block competition and/or convey meaningful pricing power.

Switching costs — This is when either due to time or money, the expenses a customer would incur to change from one producer/provider to another outweighs the benefits of staying put.

HOW CAN YOU FIND AND INVEST IN ‘WIDE MOATS’?

Using the ratings produced by its equity analysts, Morningstar has constructed its own US and global Wide Moat Focus Indices so as to generate high-conviction portfolios of stocks with durable competitive advantages and attractive valuations.

As they are not constrained by traditional style classifications or benchmarks, the positioning of these indices moves to wherever the most attractive opportunities are found.

According to Morningstar, ‘this unique approach combines fundamental insights with objective portfolio construction, which facilitates consistency and investability’.

There are three US indices – a large-cap version, a small- and mid-cap version and a sustainable version – as well as a global index.

To allow UK retail investors to get exposure to these, index provider VanEck has produced ETFs (exchange-traded funds) for all four priced in sterling.

The fund with most appeal is likely to be the broad VanEck Morningstar US Wide Moat ETF (MOTV), which holds 54 stocks, has a market cap of $46 million and a 0.46% total expense ratio.

For investors who want even broader exposure, the VanEck Morningstar Global Wide Moat ETF (GOAT) holds 74 stocks, has a market value of $59 million and an 0.52% total expense ratio.

Besides VanEck, insurer Legal & General (LGEN) has constructed what it considers to be a ‘wide moat’ fund under the banner of the L&G Global Brands ETF (LABL), although it is much smaller than the other funds and its top 10 holdings reads like a who’s who of tech stocks, so it is hardly any different to the S&P 500 or Nasdaq Composite.

TransUnion (TRU:NYSE)

Market Cap: $19.7 billion

Price: $101

Along with US peer Equifax (EFX:NYSE) and UK company Experian (EXPN), TransUnion (TRU:NYSE) is a major consumer credit bureau providing the consumer data which lenders use as the basis for granting credit.

Barriers to entry in this market are high, and given the importance of accurate information and the amount of risk involved in lending and insurance, whatever TransUnion charges for its service is negligible to its customers, giving it strong pricing power according to Morningstar analyst Rajiv Bhatia.

To give some idea of scale, there is around $1 trillion of outstanding credit card debt in the US, which generates around $1 billion of annual revenues for the three firms, and car loan origination is typically over $700 billion per year, which generates another $600 million or so in annual revenue.

Currently, over three-quarters of TransUnion’s revenue comes from the US, but the company is looking to replicate its success further afield, and Bhatia believes India, with its large population and rising incomes, could be an evergreen source of growth for the firm.

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