Why Buffett’s wide-moat theory works for investors

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Warren Buffett likes firms with simple businesses that are hard for competitors to take on. They’re like giant castles with big moats around them. The wider the moat the better.

Mr. Buffett turned his passion for moats into a great fortune. He compounded Berkshire Hathaway’s (BRK-A-N) book value per share at an average annual rate of 19.1 per cent from 1965 through to the end of 2017. The decades of success attracted many admirers and imitators.

Financial research firm Morningstar (MORN) adopted the moat concept and ran with it early this century. Their team of analysts rate the strength of a company’s moat, which encapsulates their view of the firm’s sustainable competitive advantage. The idea being that the firms with wide moats can foil the competition and earn high returns on capital for many years. Those with narrow moats or no moats aren’t as strong.

I like Morningstar’s moat system and perked up when I ran across a new study of its returns. The CFA Institute Research Foundation recently published a book called Popularity: A Bridge between Classical and Behavioral Finance written by Roger G. Ibbotson, Thomas M. Idzorek, CFA, Paul D. Kaplan, CFA, and James X. Xiong, CFA. It explores the intersection of popularity and asset pricing.

One of its new empirical findings focuses on Morningstar’s moat ratings as a proxy for popularity. The notion being that companies with wide moats are more popular with investors than those that lack moats.

As a test, the rated stocks were sorted into three portfolios each month based on the strength of their moats. The portfolios were equally weighted and their returns tracked from July, 2002 to August, 2017.

The wide-moat portfolio generated a compound annual growth rate of 11.15 per cent over the period. Not bad. But the narrow-moat portfolio climbed 12.08 per cent annually and the no-moat portfolio gained 15.40 per cent per year.

The no-moat firms beat the wide-moat firms by an average of 4.25 percentage points annually. They had outstanding returns despite their undesirable characteristics.

But – and it’s a big but – the no-moat portfolio was also quite volatile as measured by its standard deviation. The no-moat portfolio had a volatility of 23.59 per cent, the narrow-moat portfolio clocked in at 16.08 per cent, and the wide-moat portfolio hit the 13.26-per-cent mark.

That’s a huge spread. While the ride for the wide-moat investors was relatively smooth, the no-moat portfolio would have given most investors sleepless nights. The crash of 2008 was particularly painful for the no-moat portfolio.

That’s why it’s useful to consider the Sharpe ratio of each portfolio. The ratio measures excess returns per unit of volatility. Higher ratios are better and the wide-moat portfolio shines with a ratio of 0.82. The narrow-moat portfolio had a ratio of 0.76 and the no-moat portfolio trailed with a ratio of 0.73.

While the no-moat portfolio won when it came to raw returns, it got those returns at the cost of a huge amount of volatility. It’s a pattern that’s fairly common when it comes to different stock picking (and market timing) strategies.

But strong moats shouldn’t be viewed in isolation. Valuations also matter. While Mr. Buffett doesn’t mind paying up a bit for a wonderful business, it is possible to pay too much for one.

As it happens, wide-moat stocks trading at low prices compared to Morningstar’s assessment of their fair value have outperformed the market. That’s based on the Morningstar Wide Moat Focus Index, which sports average annual returns of 12.03 per cent over the 15 years through to the end of 2018. The index handily beat the S&P 500, which gained 7.77 per cent over the same period.

(The U.S.-based VanEck Vectors Morningstar Wide Moat ETF follows the strategy and charges an annual fee of 0.48 per cent.)

While moats don’t build giant castles of wealth on their own, Warren Buffett’s idea of paying reasonable prices for wonderful firms with wide moats is a good one.

Norman Rothery, PhD, CFA, is the founder of StingyInvestor.com.