With inflation fears rising, these two ETFs that track companies with sustainable competitive advantages are options to consider.
What’s the perfect company to invest in? According to Warren Buffett it is one with a so-called moat. This refers to a business with a long-term sustainable competitive advantage, which protects its market share and profits from rivals.
As Buffett himself has described it: “What we’re trying to do is we’re trying to find a business with a wide and long-lasting moat around it, protecting a terrific economic castle with an honest lord in charge of the castle.”
The idea is that the main threat to any company is its rivals. Over time, competitor firms will try to steal market share and erode the revenues of a company. The perfect company, therefore, has some sort of competitive advantage that stops rivals eating into their market share. This advantage is its moat and the wider the moat, the safer the company.
On top of that, companies with competitive advantage can often charge higher prices without the risk of losing market share.
Where do moats come from?
According to Morningstar, there are five main ways a company can gain a moat:
- Network effect: this happens when the value of a company’s service increases as more people start to use it. The obvious example here is a social media platform. This makes it hard for rivals to gain a foothold in the market.
- Intangible assets: patented drugs, unique software or production processes, branding and other intangible assets can prevent competitors from copying a company’s products. This can also mean the company can charge higher prices.
- Cost advantage: companies that have a structural cost advantage can offer lower prices than competitors, defending their market share. Or, such companies can charge the same as rivals and earn relatively higher margins.
- Switching costs: if changing product is too costly or troublesome for the consumer, the company has less risk from competitors and can potentially charge higher prices.
- Efficient scale: in some sectors, the cost of servicing the market is so high it deters new entrants. Costs are so high that new entrants would cause returns for all players to fall to too low a level to be worth it. The classic example here is oil and gas pipelines.
Most companies deemed to have an economic moat will have some combination of these, to varying degrees.
So does a moat translate into better share price performance? Using the Morningstar Wide Moat Focus Index, data from FE Analytics shows that historically they have. Over the past five years, the Morningstar Wide Moat Focus Index has returned 155.8% compared to 98% for the MSCI World Index (pound sterling, total return). Over 15 years, the gap is even wider, 741.3% versus 256.6%.
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The Morningstar Wide Moat Focus Index uses the Morningstar Economic Moat Rating methodology, which assigns an economic moat rating to companies from the five sources of competitive advantage mentioned above. However, it also screens for companies it deems to be trading at attractive valuations.
Companies with a moat may be about to get more attractive.
As many commentators have noted, the era of low inflation may be coming to an end. In the short term, some worry that the US government’s huge fiscal spending plans will push spending above capacity. On top of that, there is a lot of pent-up demand ready to be unleashed once lockdowns end.
Whereas in recent history such signs of inflation would have been met by swift interest rate rises from vigilant central bankers, that may not happen this time. Most notably, the US Federal Reserve has signalled that it will be more tolerant of inflation in the short term, allowing the economy to “run hot” in the hope of improving employment and wages.
This should force investors to think hard about the type of assets they hold in their portfolio and what inflation will mean for them. When it comes to their equity allocation, investors should ask what type of companies will perform better in a more inflationary world. And this is where companies with economic moats come in.
A key part of having an economic moat is pricing power. Companies with strong intangible assets, network effects, high switching costs and cost advantages all have the power to charge higher prices without risking losing market share to rivals. This is potentially a great benefit in a world of higher inflation.
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Higher inflation means higher input costs for companies, be it raw materials or the wages of workers. For many companies, these higher costs will force them to choose between raising prices at the risk of losing market share, or keeping prices down but seeing smaller profit margins. Either way, inflation hurts.
Companies with strong competitive advantages do not face this dilemma. In theory, firms with strong economic moats can pass these costs on to consumers, keeping margins high without threatening market share.
ETFs to access moat companies
So how should investors convinced of the case for economic moat companies put this into practice?
Currently, this ETF has 68 holdings, but this can change depending on Morningstar’s regular reviews of the index. The minimum number it can hold is 50.
As for the current holdings, as at the end of January 2021, the ETF’s largest holding was Chinese tech company Baidu (NASDAQ:BIDU), representing 3.3%. This was followed by Tencent (SEHK:700) with 2.4%. A couple of other well-known tech firms were also in the top 10, such as Microsoft (NASDAQ:MSFT) and Alphabet (NASDAQ:GOOGL).
However, the fund is not full of overvalued tech holdings, with Morningstar including valuation in its index construction. It currently sits on a 12-month trailing price-to-earnings ratio of 25x, lower than that of the MSCI World Index.
The other option is the VanEck Vectors Morningstar US Wide Moat ETF (LSE:MOAT). This index is composed of US companies with strong moats and attractive valuations. It is slightly cheaper than the global version, charging 0.49%.
This ETF’s portfolio is composed of 49 stocks and will usually have somewhere between 40 and 60.
Currently, the ETF’s portfolio looks very different to the wider US market. Its biggest holding is publisher Wiley (NYSE:JW.A), at just over 3%, followed by financial services firm Charles Schwab (NYSE:SCHW) and agricultural chemical company Corteva (NYSE:CTVA), with similar weightings.
In part, this is a result of Morningstar’s index review in 2020, which resulted in a notable reduction of big tech firms and other growth-oriented stocks, in a move to shift towards value stocks.
So, for example, while the roughly half a dozen big tech companies account for around a quarter of the S&P 500, only Amazon (NASDAQ:AMZN) and Microsoft sit in the US moat index, each accounting for around 2%, meaning they are not even in the top 10 holdings.
So alongside offering investors exposure to stocks that should benefit long term from their moat, as well as protecting against inflation, the ETF would be another way to play the supposed return to value and the reflation trade. It would also mean reducing your risk of being exposed to a supposed tech bubble.
Of course, the risk here is that we don’t see a return to value, reflation or a decline of tech stocks. If tech and growth stocks continue to shrug off the bears and outperform, this ETF will likely end up underperforming. Indeed, that was the case in 2020.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
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