"Buy wide moats at good prices." If you are a veteran Morningstar reader like me, you've probably seen this message so many times in so many manifestations that your brain immediately shuts down whenever you encounter it in a new form. While I sympathize, I’m not going to apologize for repeating myself, for this method tends to work pretty well over time.
However, to avoid putting you to sleep, I’m going to put a new twist on the concept of moats to kick off our new blog, and tie it into a part of my work at Morningstar, which entails looking at no-moat companies, a dusty and often forgotten corner of the our investing universe.
My message is simple: I’ll take a Growing moat over a Wide moat any day!
This may sound anathema, but it isn't at all when you think about it. The quality of a company’s existing business is often very apparent. Crack open the financials and whip out the calculator, and you can often tell if a business is any good in a few keystrokes. Sounds easy, right? Of course! And that's the problem. If it’s too easy, everyone else can figure it out too.
With its legions of investors, batteries of computers, and swarms of algorithms, the market is very, very good at discounting the past. But, fortunately for you, it’s not too smart about the future. And therein lies the opportunity.
Think about what happens when a company’s moat is growing. Its margins often grow, allowing it to invest ever larger sums back into itself, improving the business even further. Its earnings, and returns on capital and equity also grow, luring in even more investors--leading to "multiple expansion", in street parlance. Who cares whether the company had no moat, a narrow moat, or wide moat to start! The size and depth of the moat five, or ten years in the future is the only criteria that matters. In fact, if the company started out as a no-moat, it simply means that it has more room to dig!
On the flip side, think about what happens to a great business that starts a slow decline. Revenue growth often slows, margins shrink. Returns on capital and equity also shrink, and possibly become more volatile. The company often cannot profitably reinvest in itself at the same rate, leading to a downward spiral. At this point, the company probably isn't terrible. In fact, it may earn decent returns on capital for years, qualifying it for a moat. But I probably wouldn't touch it except at a thrift store price.
The market often anchors on the company’s past financials, and underestimates, or even ignores, the evolution of the business itself. Even us enlightened Morningstar analysts are hardly immune to this. To illustrate my point, I’m going to quote from some old analyst reports for Monsanto
MON, dated 2001 to 2002. If you can believe it, we had rated Monsanto as a no-moat, high uncertainty company. Now, I consider Monsanto one of the most defensible, highest quality companies in the world.
This is what we said in 2001:
"Monsanto gets 70% of its revenue from its hugely successful Roundup line of herbicides and insecticides, but that product has lost patent protection; thus, competitors will be able to offer generic substitutes, which will erode margins in the coming years."
"But without major worldwide markets opening for GM seeds and crops, Monsanto will have difficulty differentiating itself from better-funded competitors, like DuPont's Pioneer Hi-Bred."
The following is the title of a report from 2002:
"Monsanto’s penchant for getting itself in hot water prevents us from recommending its shares."
Granted, if you read the full reports, the analysts in question (no longer at Morningstar FYI) recognized the growth potential of the business. But we dramatically underestimated the growth rate, the margin expansion, and the future value of Monsanto’s franchise--leading to a golden missed opportunity.
I personally believe that our no moat coverage universe is rife with such opportunities, just waiting to be discovered with some patience and a discerning eye. However, because these companies are rated no-moat, we seldom single them out for investor pitches. That’s where Justin Perucki, my colleague, and I come in. In the coming months, with a lot of elbow grease, we hope to unearth and bring you these hidden gems... So wish us luck!