The advantage of economic moats

One of the things to look for when considering an investment is the width of the company’s economic moat.

The term was popularized by Warren Buffett as a metaphor for the water-filled ditches that surrounded medieval castles. Just as those moats provided protection from invaders, economic moats do the same thing. They protect a business from the competition.

Economic moats are often intangible things. They can be a better or more sophisticated product that broadens the customer base. Or access to cheap raw materials that allow for low-cost production. Global brand recognition is another. Strong marketing and distribution relationships keep customers close, making it harder for them to switch. If you’re like me, maybe you have an iPhone, iPad and Apple watch. It’s not likely I’ll switch to a Google or Samsung android phone or tablet anytime soon. Apple has me in velvet handcuffs.

Morningstar Research feels moats are important enough attributes that it has come up with a 5-star rating from weak to very strong that it applies to all companies it rates. Morningstar sums them up as enduring competitive advantages. If it expects the competitive advantage to last more than 20 years, that’s considered a wide moat. If it can fend off rivals for 10 years, it has a narrow moat. If the advantage is fleeting, there’s no moat.

I recently wrote about Intuitive Surgical Corp. (NDQ: ISRG), a company whose surgical robot was the first to be approved by the US Food and Drug Administration (FDA) in 1997. Its moat is a big lead over its competitors who have robots of their own that might be just as good or even better. The difference is that its da Vinci system is now in its fifth iteration with version five receiving FDA approval in March after more than a year of tests. Its competitors are testing versions one and two. They have a long way to go to catch up and, in the meantime, it won’t be that easy to persuade hospitals and clinics using Intuitive’s tools to jettison them for something that’s similar.

Weight loss drugmakers Eli Lilly (NYSE: LLY) and Novo Nordisk (NYSE: NVO) likewise have big competitive leads. They have drugs that are very effective with new uses coming to light. Both have passed regulatory hurdles that include tests and trials that take years. Both are improving their formulations as they go.

Lilly has discovered that Wegovy’s weight loss formulation reduced the risk of heart attacks. It also found that Wegovy helped reduce episodes of irregular breathing in patients with sleep apnea across two late-stage trials. Both represent new markets.

Both companies are unable to produce enough of their weight loss drugs Ozempic and Wegovy and see no end to the shortages. They are adding new factories and expanding current ones. Novo Nordisk recently announced another investment to expand production capacity. This one is a US$2.3 billion investment in France. Morningstar rates all three of these companies as having wide moats.

Last week, Novo Nordisk beat first-quarter profit expectations with net income rising 28% year-over-year to US $3.65 billion. Wegovy sales more than doubled.  The company noted that Wegovy has been approved in the U.S. for cardiovascular risk reduction in people with obesity.  

High moat, high growth companies often come with high price-to-earnings (p/e) ratios, which tends to worry investors. Lilly’s trailing 12-month p/e is 134 and Novo Nordisk’s 48.2. Chipmaker Nvidia and Microsoft, discussed below, are at 68.9 and 34 respectively.

While p/e ratios are certainly something to keep in mind, it’s not necessarily a reason to avoid high ratio stocks. A high p/e reflects an above average ability to earn a return.

Sometimes what looks like a moat isn’t. Hydro One (TSX: H), the monopoly that transmits 98% of Ontario’s electricity, would seem to have a big one. It faces no competition, is growing at a steady pace, and has increased its dividend in each of the last eight years.  Yet in the opinion of Morningstar equity analysts, Hydro One has no moat at all.

That is because the province owns 47% of its shares and on a whim can fire the current board – as the Ford government did in 2018. Likewise, the party in power could use its majority to pass a law capping Hydro One’s rate of return. It’s certainly a risk, though it’s all quiet for now.

Wide economic moats are one thing to consider when building a diversified, all-weather portfolio. They are one tool among many to help you form a judgement.