This morning, I wrote about competitive advantages — and how many "growth" investors have no idea how these advantages interact with investing returns.
Another name for a "competitive advantage" is "moat", like the ring of water which protects a medieval castle.
No moat = No Worries*!
After I wrote that article I received a message from a friend who enquired about the idea of the 'strength' of a competitive advantage/moat.
In my article I used the example of Greencross Limited (ASX: GXL), Australia's leading pet store and vet business, and said that it did not have a wide, durable moat.
You can make bucket loads of cash by investing in businesses with narrow or no moats, but, as I noted earlier: invest for a good time, not a long time.
Don't take it from me
English is my fourth language.
(not really, it just seems that way!)
I have a habit of making no sense, at times. So consider this chart from Morningstar, the financial research heavyweight:
The file "moat-roic" was aptly named since "roic" means Return on Invested Capital.
Morningstar's research team articulate my point more eloquently than I did:
"We believe low-quality, no-moat companies will see their normalized returns gravitate toward the firm's cost of capital more quickly than companies with moats."
The team goes on to say, "We have identified five sources of economic moats: intangible assets, switching costs, network effect, cost advantage, and efficient scale."
3 of my Favourite ASX Companies with Dangerously Wide Moats
Xero FPO NZ (ASX: XRO)
Xero is the Kiwi accounting software provider. I'm not sure exactly how powerful its competitive advantage will become, but it is growing. With its online software fulfilling a complex task for many small businesses, switching costs are high and the growth in its user base is one of the big reasons its efficiency is improving and its moat is widening. However, its moat is not impregnable in my opinion, especially with rivals like Intuit.
Gentrack Group Ltd (ASX: XRO)
I have been writing about Gentrack a lot in 2017. It is also a software business with a subscription type model. Gentrack is a specialist software developer for the energy and water utilities markets, and airports. Its product embeds deeply in their systems and processes, creating high switching costs.
APA Group (ASX: APA)
APA Group is a name you might not know, but whose services you use every single day. APA Group is Australia's largest provider of gas infrastructure like pipelines and distribution centres. While it's not impossible for a company to replicate APA's business, it undoubtedly has a moat. Not only does it have high switching costs (what's the alternative to using the only pipeline network within 50km?), it also has a cost advantage over potential competitors. In addition, APA benefits from scale efficiencies when new customers are added to the system. All these features combine to create a powerful 'captured audience'.
Foolish Takeaway
Facebook, Apple, Amazon. These are the names of dominant companies changing the world. They also have the widest of wide moats.
But closer to home there are other, smaller, companies with competitive advantages.
Buying a company with a durable competitive advantage doesn't guarantee returns — especially if you overpay for the shares. But if you're a long-term (i.e. five years plus) investor, I don't know why you would invest in anything else unless it was dirt cheap!
