Investors are always looking for ‘safe’ investments. Here are two attributes that signal quality and may provide shelter through all markets conditions.
Dealing with uncertainty is a constant for investors. But it feels a little more uncertain than usual right now as inflation has returned and a period of ultra-low interest rates ended with a dramatic change in direction from central banks. Uncertainty can cause temperamental markets, but as investors, there are characteristics we can look for in investments that give us room to breathe – margin and moat.
First, we can explore the concepts. Then describe why they matter so much in the current environment and how investors can find attractive opportunities.
At a high level, margin refers to how much a company keeps of what they sell. The basic concept is that a company sells a good or service for a certain price, and then there are expenses related to creating that good or service and running the company. The margin is the difference.
While there are different margins that allow us to look at different aspects of a company’s performance, one of the most important figures is the net profit margin (dividing the profit by the revenue). An example would be if a company had revenue of $100, and a profit of $50, the net profit margin is 50%.
The second factor is moat. An economic moat refers to a company’s ability to keep competitors at bay.
Capitalism is competition. A capitalist economic system means that companies are competing for customers. In general, that competition revolves around producing a better good or service, offering lower prices or some combination of both – a quality good at a reasonable price.
This is good for us as consumers. As companies compete for our business, we get better goods and services at cheaper prices.
As investors we would prefer less competition. The more competitive the environment the more a business needs to constantly respond to their competitors. Businesses must constantly invest in their products and services to remain competitive – and that costs money. On the other side of the burning candle is pricing. Prices need to be kept low and money must be spent on marketing to get consumers to buy them.
If the company must invest in creating better products or the company must cut prices, that means less profit. As the owner of the company that means less profit for us as investors.
We want to find companies that can fend of this competition through a competitive advantage. And we want this competitive advantage to be sustainable. We want to find a companies with moats.
Sustainability is key. Companies tend to obtain temporary competitive advantages quite often – this could be by reducing price or being first to market. For instance, Myspace had a competitive advantage by being the first mover in social media. They launched on August 1st, 2003. Facebook didn’t launch until February 2004. Their competitive advantage was not sustainable, and Facebook took over and dominated the industry. They did that because users felt they had a better product.
Yahoo Search is similar. Yahoo started in 1995 with Google launching three years later. The rest is history.
Companies need both a competitive advantage, and the ability to maintain it over the long-term. At Morningstar, we have two different moat ratings – narrow moat (ability to maintain a competitive advantage for at least 10 years) and a wide moat (ability to maintain a competitive advantage for at least 20 years).
For many investors, a moat can feel conceptual. In a way it is. Determining if a company has a moat involves studying the industry and the competitive dynamics around a company. It means understanding what consumers are looking and what causes them to switch from one provider to another. It means understanding if there are structural issues or legal statutes that protect a company.
The advantages stemming from a moat are far from conceptual.
Where moat and margin meet
The results from moats are tangible. One example is margin. Continually investing more in producing better goods or services means that a company makes less money since their costs go up. Selling goods for cheaper means a company makes less money. A case of competition being detrimental for us as investors.
Why it’s important in the current environment
It is extremely important for investors to pay attention to margin in the current environment. Margin provides a buffer against inflation and interest rates. As investors, we want the companies we invest in to maintain a net profit margin and remain profitable. Remaining profitable allows companies to distribute dividends, reinvest in the company for potential future growth, or strengthen their balance sheet. It is also important to be wary because margins right now are historically high.
Between 2000 and 2011, the margin on the S&P 500 was 6.2%. Over the past decade, it accelerated to 13.4%.
When we look at earnings growth, much of it can be attributed to margin expansion. The environment that we’ve been in since the early 1980s has been lower taxes, less bargaining power for workers, increased globalisation and increased efficiency through technological advances, including the computer, internet and automation. This has all been extremely positive for companies.
High interest rates, inflation, and re-thinking of global supply chains post-Covid may bring down margins. A reversion to the mean could be serious. If the S&P 500 went back from 13.2% to 6.2% and valuation levels didn’t change, that would represent a 46% drop in the index. This would not be immediate, but a slow reduction in margin could slow down earnings growth going forward. And it may be happening. According to FACTSET the S&P 500 margin has dropped 7 straight quarters. In Q1 2023 it was 11.2%.
Moats protect margin. We can use the Big 4 banks as an example. The Big 4 in Australia have all been awarded wide moats by our equity analysts. Their competitive advantages come from their formidable market share that is strengthened by ‘switching costs’. Switching costs refer to the reluctance of customers to switch banks. They also have cost advantages due to scale. This means that they can spread fixed costs to a wider customer base and get cheaper funding from both depositors and on the wholesale market.
Let’s pick one out of the pack. Commonwealth Bank (ASX: CBA) has had a net profit margin of around 40% which has been relatively stable. If we look at a much smaller bank without a moat, Bank of Queensland (ASX: BOQ) had a net profit margin of around 25% for the past five years. That is a big difference.
Being able to make a larger percentage from every dollar is what shareholders want. In every environment that is a good outcome.
How should investors analyse margin?
Think about the underlying business in the same way you would think about a small business. It’s very easy to get caught up in earnings season and market announcements and all the noise we deal with as investors. Over time, we must be laser focused on a company’s ability to grow earnings. They do this by selling more, or keeping a higher percentage of what is sold.
In an ideal world, they are doing both. With large established companies that have high margins, look at the trend and how margins have changed over the years. Certain years can be an anomaly, so five-year averages may give you a better picture.
With younger firms, look at trends but understand that there may be more volatility. If there are big changes, try to understand why and whether it is just an anomaly. Look at the gross margin (difference between sales and cost of goods sold). Often companies at this stage will be investing in growth activities, but the gross margin will not include this spending. If the gross margin has improved over time, this is an indication that the company will benefit from scale.
Further resources for investors
Mark LaMonica, CFA recently conducted a webinar on ‘How to Evaluate a Company’s Fundamentals’ . This webinar takes a deep dive on what constitutes a ‘good’ company (including moat and margin), and how to value them.