Wide-Moat Growth Strategy
| Umberto P. Fedeli
One of the strategies we employ is what we call Wide-Moat Growth or sometimes we refer to this as forever quality value growth compounders. These are some of the greatest companies in the world, less than 1% of publicly traded companies would be in this category. Often these companies are fully priced, but occasionally there are opportunities after a period where the stock lagged in the market or during a market correction. For example, in March of 2020 when the pandemic started, most stocks were hit significantly; or during the Great Recession of 2008 - 2009. These are times when the market is very fearful, but there are windows of opportunity.
We find when there is fear and uncertainly, it creates volatility. The volatility creates dislocations of value and unusual opportunities. In the long-run, volatility is not the same thing as risk and volatility can be the friend of the long-term investor. When there are high levels of fear in the market, the market goes down quickly, and this can be uncomfortable. However, we’ve never had a crash or correction we didn’t recover from.
While we do evaluate both quantitative and qualitative factors, we also ask the questions, is this a short-term problem or a long-term problem? Is this a public relations (perceived) issue or a structural/operational issue? Are they getting painted with the same brush? Does the company have a dominant position? Are they the exception in their category or class?
The stock market goes down faster than it goes up. However, it goes up longer than it goes down. In fact, throughout U.S. history there has been an 88% chance the market will produce positive returns after 5 years; if you hold for 10 years, it’s roughly 97%.
Warren Buffett coined the word “moat”, which is a business with competitive advantages. A company with a “wide moat” is a company with substantial and sustainable competitive advantages. In many cases, these companies have a high return on invested capital. Some of the characteristics of wide moat companies are:
- Cost advantages (Walmart)
- Brand recognition (Nike)
- Size advantages (Visa & Mastercard)
- Technology advantage (Google)
- Network effects (Facebook)
- High Switching costs (Software)
- Patents (Pharmaceuticals)
- Intellectual Property (Disney characters)
- Counter-positioning incumbents (Netflix vs Blockbuster)
These are companies so wonderful you typically never want to sell them. You’ll sleep well at night owning them through market corrections and recessions. Because you are going to hold long term, when and if there is a substantial price decline, instead of worrying or panicking, you can use the opportunity to acquire more shares. View the opportunity in a positive light as buying a great business “on sale”.
On the other hand, there are some industries that are highly competitive, where it is hard to build a wide moat. The primary differentiator is often management, but if there’s not a wide moat, that is not enough. In order to stay competitive, organizations usually result in reducing prices, spending more on marketing and/or service to gain market shares—which will ultimately cut into profits. As a general rule, we tend to avoid these: highly cyclical companies, slow growers and weak niche industries that don’t offer unique visibility.
Visibility is the ability to see the competitive dynamics and have reasonable projections about the future revenue and profits. Durability is the ability of the company to maintain satisfactory rates of revenue growth. These two are the cornerstones of our criteria across all our strategies—and a wide moat increases visibility and durability.
We prefer to own companies that can continue to grow revenue and free cash flow at double-digit returns. This means that if you buy them at attractive valuation multiples, you can just hold them so long as they continue to grow at attractive rates. Companies with wide moats eventually become obvious to everyone: Visa, Mastercard, Adobe, DocuSign. These companies have dominant market share and sustainable competitive advantages so strong they will be the market leaders for decades.
It’s important to remember that no matter how great the stock, it won’t outperform every year. In the public markets, volatility is the price you pay for outperformance. Consider a few of the great companies of the past decade. Google has returned approximately 22.5% annually from 2009 – 2020 and underperformed the S&P 500 in 5 of those years. Amazon returned roughly 41% annually over that same period and underperformed in 4 of those years. Netflix returned roughly 50% annually over the same 12 years and underperformed in 4 of those years. Salesforce returned roughly 32% annually to investors over the 12-year period and underperformed in 5 of those years.
In other words, owning a concentrated portfolio of some of the best companies on the planet can still lead to underperforming the S&P 500 in 4 to 5 out of 12 years. If you are invested in stocks, what should matter to you is long-term returns, not consistency of returns. And if you want high long-term returns, look for hypergrowth companies building a wide moat, or ones that have wide moats and attractive growth. Next article I will talk about the process we use to identify hypergrowth companies building moats.