Investment moats is the competitive advantage of a company that allows it to fend off competition from its rivals and enable it to earn excess returns for many years. According to Morningstar’s Why Moats Matter, there is a stock research process which guides investors on how to invest in great businesses at the right time and make money from the stock market.
The process involves a bottom-up approach which requires investors to identify the company’s moat(s), establish the fair value and determine the margin of safety. On the surface, it may seem straightforward but when you put it into practice, it is not so simple.
According to Morningstar’s investment framework, there are five main sources that a company may possess: intangible assets, cost advantage, switching costs, network effect and efficient scale. Now why is having a moat source important from an investor’s point of view? If you recall that 15 years ago, Nokia used to dominate the worldwide mobile phone market and boasted the majority market share for a number of years. However, the entry of Apple’s iphone in 2007 changed the game and led to a dramatic shift towards smartphone, leading to Nokia losing its status as the market leader. Therefore in a competitive market, a firm must have the ability to withstand the onslaught of competition for a long period of time. Otherwise, growth would not be sustainable.
If a house is worth $300,000, would you pay $450,000 for it? You might probably do so if you like the house very much and intend to stay in it for a long time. However, if the house is meant for investment purposes, you would benefit from the capital gain from the sale of the house if you sell the house above $450,000. But that is only if you have the holding power and patience to wait until it appreciate to a value much higher than $450,000. Likewise in the equity market, there are opportunities to buy stocks below their intrinsic values. Don’t buy stocks when the market is bullish and when many stocks are trading at ridiculous prices above their fair value.
There are several ways to establish a fair value of a company. One way is through looking at the current price and earnings, in short the P/E method. Based on this metric, you estimate the future cash flow and growth rate. Morningstar’s approach is to use the discounted cash flow metric which looks at the revenue, earnings and balance sheet for the next few years and then discount these values to the present using the weighted cost of capital (WACC).
Margin of Safety
If you go shopping, would you prefer to buy that watch that you desired for a long time at a bargain? In stock market, you stand a good chance of not losing money if you have bought the stock at a price worth than the value which you had estimated. This is the hallmark of a successful investor but it is not easy to achieve this because no one can accurately pin point the actual value of a stock.
To ensure that the odds are in your favor, the best time to invest in stock is during black swan events – stock market crashes.
SG Wealth Builder